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General overview to interest expense limitations and their rationale Basics of interest tracing rules of Reg. 1.163-8T and related Notices Limitations: Personal interest Interest on education loans (IRC 221) Investment interest + interest related to tax-exempt activities Home mortgage interest.ZZXInterest expense  pre-classification issues--&Possible tax issues: Is a prepayment penalty interest? If a closely-held corporation loans money to a shareholder/employee, is it a bona fide debt that could produce interest expense or is it a distribution or compensation? Debt v equity Non-recourse debt might warrant greater scrutiny (EX  Rev Rul 7-110) Is market interest being charged and if not, must interest be imputed?*ZfZf What is debt?4Naguchi, 992 F2d 226 (9th Cir. 1993)   To be deductible under section 163(a), the obligation on which interest is based must be an "existing, unconditional and legally enforceable obligation for the payment of a principal sum." Howlett v. Commissioner, 56 T.C. 951, 960 (1971). A debt must be an existing and genuine obligation in order to give rise to deductible interest payments. As we explained in Estate of Franklin v. Commissioner, 544 F.2d 1045, 1049 (9th Cir. 1976), "a mere chance that a genuine debt obligation may arise ... is not enough to justify an interest deduction. To justify the deduction the debt must exist; potential existence will not do.  dZ "  0 0 ;AWG Leasing Trust v. U.S., 592 F Supp 2d 953 (ND Oh, 2008)  <&"& The Supreme Court has generally defined  interest as  compensation for the use or forbearance of money. See, e.g., Comm'r v. Nat'l Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 145 (1974) (internal citation omitted). In order for a taxpayer to take such a deduction, however, the underlying debt on which the interest is paid must be genuine. Bridges v. Comm'r, 325 F.2d 180, 184 (4th Cir. 1963). See also Goldstein v. Comm'r, 364 F.2d 734, 742 (2nd Cir. 1966), cert. denied, 385 U.S. 1005 (1967) (holding  Section 163(a) does not  intend that taxpayers should be permitted deductions for interest paid on debts that were entered into solely in order to obtain a deduction ). In deciding whether economic advances made to a corporation are true debt, courts must consider  whether the objective facts establish an intention to create an unconditional obligation to repay the advances. Indmar Products Co. v. Comm'r, 444 F.3d 771, 776 (6th Cir. 2006) (citing Roth Steel Tube Co. v. Comm'r, 800 F.2d 625, 630 (6th Cir. 1986). Pk<&' -(  0pq  0 0  0AWG - continuedX  The Sixth Circuit has embraced the Second Circuit's definition of  debt for tax purposes as: [A]n unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor's income or lack thereof. While some variation from this formula is not fatal to the taxpayer's effort to have the advance treated as a debt for tax purposes, ... too great a variation will of course preclude such treatment. The question becomes, then, what is  too great a variation ? Indmar Products, 444 F.3d at 776 (citing Gilbert v. Comm'r, 248 F.2d 399, 402 03 (2nd Cir. 1957) (internal quotation marks omitted). xP`PLP`N bc 0ac ,Who can potentially deduct interest expense?--&Assuming it falls into a deductible category & Generally, the person legally liable and who pays it Reg. 1.163-1(b)   Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness. &/E/E Clarification of 1.163-1(b)Golder, Jr., 604 F.2d 34 (9th Cir. 1979) Excerpt:  Taxpayers do not challenge the Tax Court's conclusion that they were not directly liable on the Rancho Vistoso indebtedness. Nor do they dispute that a deduction for interest under section 163 cannot ordinarily be taken unless the interest was owed on the indebtedness of the taxpayer. They argue, however, that Treasury Regulation section 1.163-1(b) creates an "exception" to this rule which would entitle them to deduct the payments they made as guarantors of the corporate obligation. Reg. section 1.163-1(b) provides: "Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness ...." Taxpayers argue that while it is the intention of section 163(a) to deny an interest deduction where the taxpayer's liability is secondary or indirect, Reg.1.163-1(b) creates an exception to this rule where the secondary liability is secured by a mortgage on the taxpayer's real estate. We do not agree. Reg. 1.163-1(b) must be read in its proper context, i.e. in light of its parent statute, section 163(a). Section 163(a) permits an interest deduction only on the taxpayer's own indebtedness. Reg. 1.163-1(b) does nothing more than permit the deduction of interest in situations where the taxpayer-borrower is not personally liable on a mortgage of property which is used as security for a loan made to the taxpayer. For example, a taxpayer purchases land paying part of the purchase price in cash and the balance with a non-recourse note secured by a mortgage on the land; there, in the event of default, the creditor may look only to the property. Although the taxpayer is not directly liable on the debt since the creditor may look only to the pledged property for repayment Reg. 1.163-1(b) permits the taxpayer to deduct interest payments since the default affects only the taxpayer and no one else. The taxpayer must pay the interest to avoid foreclosure of his ownership interest in the property. Thus Reg. 1.163-1(b) does not create an "exception" to the statutory rule of section 163(a) that interest is deductible only with respect to the indebtedness of the taxpayer, but simply recognizes the economic substance of non-recourse borrowing. Reg. 1.163-1(b) permits the taxpayer-borrower in such cases to deduct the interest on the loan even though the taxpayer is not personally liable on the loan. )PPPP         k 0 0rs  +Overview to individual interest limitations,,&Why needed: 469  to determine PAL, must know how much interest expense associated with the activity 163(d)  a limitation had been around even before TRA 86 After TRA 86 and new limitations for PAL and personal interest and home mortgage interest, needed to know what was investment interest and what was not To apply rule for disallowance of personal interest added by TRA 86N D D (Authority to issue interest tracing regsn469(l)(4)   Regulations. The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out provisions of this section, including regulations (4) which provide for the determination of the allocation of interest expense for purposes of this section General authority under 78056ll Interest tracing basicsReg. 1.163-8T (TD 8145; 7/1/87) Basic rule -8T(a)(3)   Manner of allocation. In general, interest expense on a debt is allocated in the same manner as the debt to which such interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures. This section prescribes rules for tracing debt proceeds to specific expenditures. &Z96 %What is included in interest expense?s1.163-8T(c)(2)(ii)(C): Relevant provisions of the loan agreement OID rules Unstated interest per 483, 1271 - 1275&]] FExamples  categorize the following~Interest on auto loan from Ford Motor Credit Corporation for personal auto. Interest assessed by IRS upon audit of last year s Schedule C. Interest on auto loan where car is used 60% for business, borrower is an employee Interest on Visa credit card where about 50% of each bill is for employee business expenses Same as (4) but borrower is an active partner in a partnership Loan proceeds are deposited in a non-interest bearing checking account.nP #Mechanics of Interest Tracing RulesSomewhat complex and detailed. Special rules provided for: How the money was rec d (in cash, in an account, seller-financing (no proceeds rec d)) Special  pretend rules  15-day one in regs supplemented by 30-day rule in Notices Repayment ordering rules Change in loan proceeds rules More funds deposited into an account Refinancing Passthrough entities*;(;(Allocation period of -8T(c)(2)Begins on date proceeds used or treated as used to make an expenditure and ends on earlier of date debt is repaid or reallocated to a different expenditure Start includes when the proceeds are sitting in borrower s account. Label the interest expense based on how debt proceeds used. Does not matter if taxpayer pays interest late when the debt has been reallocated to a different use*eeWays of borrowing moneyLender keeps the proceeds (seller financing) -8T(c)(3) Borrower received in cash -8T(c)(5) Funds deposited into borrower s account -8T(c)(4)t-  ( -  ( 'Debt proceeds not disbursed to borrower((&-8T(c)(3) Categorize by treating as if borrower did receive funds and used them EX  buy rental property and assume the debt on it. Assuming is a passive activity, have passive activity debt and interest expense Is no 15-day rule (or 30-day rule) applicable6P.P.!Debt proceeds distributed in cashb-8T(c)(5)  generally, trace to use, otherwise, interest is assumed to be personal 15-day  pretend rule  B may treat any cash expenditure made within 15 days of receiving the cash as made from the debt proceeds Notice 89-35 modifies the 15-day rule to a 30-day before or after rule EX  B borrows $30,000 in cash on 5/1/08 and uses it to pay personal bills on 5/1. B should look to any other cash expenditure made between 4/1/08 and 5/31/08 that would produce deductible interest and  pretend that the cash was really used for that expenditure. Document it!BPGPPG"LDebt deposited into borrower s account''&-8T(c)(4) Deposit into account = investment expenditure Reallocate when debt proceeds used for another expenditure What if the account also has non-borrowed funds  which is presumed used first? -8T(c)(4)(ii)  debt proceeds treated as used before unborrowed funds and before any amounts deposited after the debt proceeds are deposited. 2 exceptions to general ordering rule: (1)  if account only has loan proceeds and interest income from the debt  may treat expenditures as from the interest income -8T(c)(4)(iii)(C) (2) 15 day rule which is modified to 30 day before and after rule by N89-35^sPPPPPsP  #*Example from -8T(c)(4) modified for N89-35++&%Additional rules for debt proceeds deposited into borrower s accountEE&V-8T(c)(4)(iii)  multiple checks written on same day  treat as written in any order -8T(c)(3)(iii)  expenditure from checking account is treated as made when check written, provided check is delivered or mailed to payee within a reasonable period after writing the check What is a reasonable time?&&^More rules for funds deposited into B s account00&-8T(c)(4)(iv)  optional method for determining date of reallocation B may treat all expenditure made during any month from debt proceeds as occurring on later of: 1st day of the month, or Date on which debt proceeds deposited in the account Benefit  may calculate interest for the entire month, rather than treat change in use of debt proceeds as occurring during the month -8T(c)(4)(v)  simultaneous deposits  if 2 or more debt deposited into account at same time, treat as deposited in order debts were incurred. If truly simultaneously created, then B may chose which was incurred first. Debt on which interest accrues at different rates are treated as separate debt. For example, line of credit with fluctuating interest rate. If draw on credit on Feb 1 at 7% rate and draw again on April 1 at 7/5% rate, have 2 different debts.EP_PNPPPE_ K  (QuestionTZena borrowed $40,000 and used it as follows (it was deposited into her checking account): $10,000 to pay off credit cards $10,000 to pay tuition for 7th grade daughter $20,000 to invest in Garden Villa Apts Ltd Partnership What type of the interest expense does Zena have and what information to you need from her to answer this question?R[t[< Ht*=Debt proceeds used to pay borrowing costs or interest expense>>&"-8T(c)(6)(ii) & (iii) If debt proceeds used to pay interest on another debt  categorize the interest on 2nd debt same as on 1st debt If debt proceeds used to pay borrowing costs of a different debt  categorize interest same as on other debt. If debt proceeds used to pay borrowing costs of that same debt (borrowing costs were added to the debt balance)  categorize same as for balance of the debt.BZj  +Debt repayment-8T(d) If debt repaid was a multi-use debt, and only part of the principal was repaid, then apply following ordering rule to determine which  use of debt was repaid: Amounts allocated to personal expenditures Investment expenditures and passive activity (other than RRE-AP)  within this class, treat repayment as going towards whichever expenditure was made first. If made on same day, then taxpayer choice. RRE-AP Former passive activity expenditure Trade or business4Z0qZ0,Debt refinancings1-8T(e) If refinanced debt is only used to pay off part of the original debt, then apply the repayment ordering rules to determine character of interest expense, assuming original debt was a multi-use debt. If refinanced debt > original debt, categorize interest on excess debt under general tracing rules.0Reallocation of debt-8T(j) General rule: debt allocated to an expenditure chargeable to a capital account must be reallocated to another expenditure at earlier of: Date original asset is sold and proceeds are used for something else Date on which use of the asset changes, such as from business to personal&2QuestionLIn 2007, B borrowed $20,000 from her bank and used the proceeds to pay off $14000 of personal debts, $3,000 to buy a new computer for her Sch C business and the balance to invest in a ltd partnership which is a passive activity to her. In 2009, B makes first payment of principal, paying $15,000. What part of the debt has she paid?3Debt & Passthrough Entities-8T(f)  (i)   reserved IRS provided the rules in Notices N89-35 provides rules on how to categorize interest expense when: A) owner borrows to acquire interest in p/s or S corp B) p/s or S corp borrows and distributes debt proceeds to owners&~w~w6CDebt related to acq of interest in passthru entity per Notice 89-35DD&8QuestionWilliam is a shareholder in an S corp and is also an employee of the corporation. William borrowed $50K to acquire stock in the corp. Is the interest expense trade or business or investment interest expense?9LQuestion  p/s borrows and distributes''&Partnership PQ s property has greatly appreciated in value and there is no debt on it. General partner thinks it would be wise to borrow $500K against the property at 5% rate in order to make a distribution to the partners. PQ s normal operating expenses are about $110K per year. Explain to general partner how the interest expense is to be reported on partners K-1s and what he should tell the partners about categorizing their interest expense.; *Policy  why tracing?Could IRS have used an approach other than tracing for the -8T regs? Preamble to -8T regs notes that some taxpayers may attempt to manipulate the tracing rules and future regs might contain some anti-abuse or special rules Other approaches IRS could have considered: Pro rate allocation Problem  what base to use? If need to allocate based on FMV of borrower s assets, would require appraisals How debt is secured  Carrying an asset  similar to old prop reg at 1.57-2(b)(1)(iii)  similar to the interest capitalization rules where expenditures exceed traced debt  avoided cost methodvEZZZmZZEm<!"How are late fees on debt treated?|Was the fee paid for the use or forbearance of money? Yes  likely is interest No  see if is a T or B expense under 162 fyi Rev Rul 69-189, 71-98, 72-315, 73-136 Bailey, TC Memo 1991-385, aff d (11th Cir,1992)  struggling business incurred regular overdraft charges/fees; held not ordinary and necessary under 162j6ZDZZZ6DIuC"Borrowing from same lenderLQuery  has the borrower really paid anything? Arguably still in same position  owes $ to original lender Battlestein (5th Cir. 1980) Wilkerson (9t Cir. 1981) Also noted in IRS Pub 535 Exception where account where 2nd loan proceeds were deposited also had other funds: Burgess, 8 TC 47 (1947)/<OU/<?4 E#Personal interest expenseNon-deductible starting with TRA 86 Rationale: BB pg 263 Deductibility created incentive to borrow Also, because supported incentive to invest in consumer items rather than investments EX  tax law doesn t require reporting of imputed rental value of owner-occupied housing But kept home mortgage int deduction because of  important policy goal of home ownership Examples? Try to avoid via HEI (although are putting home at risk) and 30-day rule of the tracing rulesv9ZZYZZZhZ9YZ  hM*!221 Interest on education loans Added by TRA 97 Rationale:  many students incur considerable debt in the course of obtaining undergraduate and graduate education. The Committee believes that permitting a deduction for interest on certain student loans will help to ease the financial burden that such obligations represent. Several limitations: Overall: $2,500 Modified AGI limits Limits based on definition of  qualified education loan and  qualified higher education expenses No deduction if taken under some other provision@**F$Investment interest limitation2163(d) and Form 4952 Deduction cannot exceed  net investment income NII = excess of investment income over investment expenses  Investment income =  the sum of (i) gross income from property held for investment (other than any gain taken into account under clause (ii)(I)), (ii) the excess (if any) of (I) the net gain attributable to the disposition of property held for investment, over (II) the net capital gain determined by only taking into account gains and losses from dispositions of property held for investment, plus (iii) so much of the net capital gain referred to in clause (ii)(II) (or, if lesser, the net gain referred to in clause (ii)(I)) as the taxpayer elects to take into account under this clause. Such term shall include qualified dividend income (as defined in section 1(h)(11)(B)) only to the extent the taxpayer elects to treat such income as investment income for purposes of this subsection. Amount not deductible in current year carries forward indefinitely subject to same limitation in subsequent yearsFPPPPrPFv`r    0 0Sc 0 0 3 0I%.Investment interest expense limitation example//&Mr. and Mrs. Smith have following for 2007. They prefer to have any income tax can be taxed at a lower rate treated that way. Sch B interest income $23,000 Qualified dividends $1,000 Int exp to acquire int in ltd partnership X (80% of assets are rental and 20% are portfolio) $3,000 Margin account interest $37,000 AGI $133,000 Investment expenses $2,500 Other misc itemized deductions $3,300PJ&AnswerInvestment income $23,000 Less: Inv expenses ( 2,500) NII $20,500 Inv int expense: Margin loan $37,000 P/S 600 ($3,000 x 20%) total $37,600 Excess to carryforward to 2008 $17,100 L^w. $E*K'Tax-exempt interest expense^265 1.163-8T(m)(2)(i)  generally,  any limitation on the deductibility of an item (other than the passive loss and nonbusiness interest limitations) applies without regard to the manner in which debt is allocated under this section. Thus, for example, interest expense treated under section 265(a)(2) as interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from Federal income tax is not deductible regardless of the expenditure to which the underlying debt is allocated under this section. 0Z0N(OHow to determine if interest expense is properly allocable to tax-exempt incomePP&Reg. 1.265-1(c)   Allocation of expenses to a class or classes of exempt income. Expenses and amounts otherwise allowable which are directly allocable to any class or classes of exempt income shall be allocated thereto; and expenses and amounts directly allocable to any class or classes of nonexempt income shall be allocated thereto. If an expense or amount otherwise allowable is indirectly allocable to both a class of nonexempt income and a class of exempt income, a reasonable proportion thereof determined in the light of all the facts and circumstances in each case shall be allocated to each. 1.163-1(d)  statement required to be included on tax return 1.163-10T(b)  QRI rules subject to 265(a). EX  borrow home equity loan and use of proceeds to purchase tax-exempt bonds then of interest expense is not deductibleDP}P>u}O)ReviewImportant to know type of interest expense an individual has Generally  apply tracing rules of 1.163-8T and Notices If secured by PR or second home  ck if QRI in which case tracing n/a Unless elect under 1.163-10T(o)(5) to treat as NOT secured by residence Planning possibilities Recordkeeping important to prove type of interest expense you have at all timesV=Z~ZHZgZ=~Hg/ ! $ ' ) -./1457:=>?@ABDGHLP Q!R"   0` 3333ff3` 3333f33ff3` "3333̙ff3` Kf3̙` &e̙3g3f` f333̙po7` ___f3̙;/f9` ff3Lm` ff3LmNLm>?" dd@*?nAd@q<nAqFLK#M n?" dd@   @@``PR    M`2p>> @(    H=? ?" `} = X Click to edit Master title style!!  @  H=? ?" ` = RClick to edit Master text styles Second level Third level Fourth level Fifth level!    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S D 6 g P  g >*  D 6g   g @* H D 0޽h ? 3380___PPT10.R`Cc 0 zr  (  x  c $̎9@ 9 R  C *Aj0239113P  H  0޽h ? 33___PPT10i.P+D=' = @B +}  0 p$(  r  S 9 `}  9 r  S X9 ` 9 H  0޽h ? ___f3̙;/f9___PPT10i.,+D=' = @B +}  0  $(   r  S 9 `}  9 r  S (9 ` 9 H  0޽h ? ___f3̙;/f9___PPT10i.+D=' = @B +}  0 $$(  $r $ S hS `}  S r $ S <+S ` S H $ 0޽h ? ___f3̙;/f9___PPT10i.s|+D=' = @B +}  0 ,$(  ,r , S +S `}  S r , S lS ` S H , 0޽h ? ___f3̙;/f9___PPT10i.@FC+D=' = @B +}  0 ($(  (r ( S ZS `}  S r ( S @[S ` S H ( 0޽h ? ___f3̙;/f9___PPT10i.܅+D=' = @B +}  0 0$(  0r 0 S oS `}  S r 0 S `nS ` S H 0 0޽h ? ___f3̙;/f9___PPT10i.Pc+D=' = @B +$  0 8$(  8r 8 S rS `}  S r 8 S sS` `  S H 8 0޽h ? ___f3̙;/f980___PPT10.|$  0 <$(  <r < S ,S `}  S r < S ԷS ` S H < 0޽h ? ___f3̙;/f980___PPT10.Q$  0 4$(  4r 4 S S `}  S r 4 S S ` S H 4 0޽h ? ___f3̙;/f980___PPT10.c$  0 @$(  @r @ S S `}  S r @ S S ` S H @ 0޽h ? ___f3̙;/f980___PPT10.Rc/1$  0 `X$(  Xr X S S `}  S r X S S ` S H X 0޽h ? ___f3̙;/f980___PPT10.`:  0 `:(  `r ` S S `}  S  ` S S ` S "hu=H ` 0޽h ? ___f3̙;/f980___PPT10.`P$  0 h$(  hr h S lS `}  S r h S 0S ` S H h 0޽h ? ___f3̙;/f980___PPT10.b$  0 p$(  pr p S HN((  r  S ; `}   '  ` H #"6* ====>==== `  1 <C?S ` Npersonal  M 0 <Q?F S L$600M / <??: F  @M . <b?- :  >M - <tk?  - K12/20M , <s?S `  MInv expM + <l|?F S  L$800M * <}?: F  @M ) < ?- :  >M ( <?  -  K11/24M ' <?S_ `  >M & <D?F _ S  @M % <?: _ F  N$1,000M $ <?-_ :  LDebt CM # <t? _ -  J6/21M " <Ǐ?S" `_  HPAM ! <lЏ?F " S_  L$700M   <я?: " F _  @M  < ?-" : _  >M  <? " -_  J2/26M  <?S`"  Npersonal  M  <?F S"  L$800M  <?: F "  @M  <\?-: "  >M  <? -"  J2/17M  <?S` >M  <?F S >M  <.?: F  L$500M  <p7?-:  LDebt BM  <?? - J1/11M  <HH?Sj` >M  <P?F jS >M  <,Y?: jF  N$1,000M  <a?-j:  JGiftM  <j? j- J1/10M  < l?S-`j >M   <p{?F -Sj >M   <?: -F j L$500M   <?--: j LDebt AM   <? --j J1/10M  <?F `- S Withdrawals  M  <|?-F - PDeposits  M  <<? -- JDateM`B 2 0o ? `ZB 3 s *1 ? -`-ZB 4 s *1 ? j`jZB 5 s *1 ? `ZB 6 s *1 ? `ZB 7 s *1 ? " `" ZB 8 s *1 ? _ `_ ZB 9 s *1 ?  ` ZB : s *1 ?  ` `B ; 0o ? ``B < 0o ?  ZB = s *1 ?--ZB ? s *1 ?F F `B A 0o ?``ZB E s *1 ?: -: ZB G s *1 ?S-SH  0޽h ? ___f3̙;/f980___PPT10.k`40W$   0 $(  r  S Ý `}   r  S ĝ `  H  0޽h ? ___f3̙;/f980___PPT10.p|}$  0 $(  r  S ˝ `}   r  S ̝ `  H  0޽h ? ___f3̙;/f980___PPT10.q%Y$   0 $(  r  S ؝ `}   r  S ٝ `  H  0޽h ? ___f3̙;/f980___PPT10.qD$  0 $(  r  S  `}   r  S  `  H  0޽h ? ___f3̙;/f980___PPT10.r9:  0 :(  r  S  `}     S \g `  "hu=H  0޽h ? ___f3̙;/f980___PPT10.s:$  0 $(  r  S g `}  g r  S T g ` g H  0޽h ? ___f3̙;/f980___PPT10.s0G$  0 0$(  r  S g `}  g r  S g ` g H  0޽h ? ___f3̙;/f980___PPT10.t}$  0 P$(  r  S g `}  g r  S g ` g H  0޽h ? ___f3̙;/f980___PPT10.w> $  0 p$(  r  S P!g `}  g r  S $g ` g H  0޽h ? ___f3̙;/f980___PPT10.w2  0 -2(  r  S )g `}  g   ` - #""  ` gP  <+g? ` Allocate pro rate among assets of entity based on FMV, book value or adj basis, reduced by any entity or owner debt allocated to such assets alreadyM  <P7g?  HAllocate among entity s assets or trace to entity s use of the funds. If the entity used funds to acquire RRE, owner would classify the interest as passive activityM  <Hg?   fExamples of reasonable methodsM  <Qg?`  8Allocate among entity assets using any reasonable method99M   <HCg?  ]Any reasonable methodM   <$]g?   m%Interest allocation method per N89-35&&M   <fg?` t,Borrow from p/s or S to acquire the interest--M    <pg? PBorrow from bank and contribute proceeds to p/s or S corp to acquire an interestQQM   <4|g?  PExample:  M  <|g?` x0 Purchases of Interests M  <g? f Contributions M  <ԏg?  @M`B  0o ? `ZB  s *1 ? `ZB  s *1 ? `ZB  s *1 ?  ` `B  0o ? ``B  0o ?  ZB  s *1 ?ZB  s *1 ?`B  0o ?``H  0޽h ? ___f3̙;/f980___PPT10.x` ]$  0 $(  r  S ]g `}  g r  S 5g ` g H  0޽h ? ___f3̙;/f980___PPT10.yj$  0 $(  r  S G9 `}  9 r  S I9 ` 9 H  0޽h ? ___f3̙;/f980___PPT10.z`$  0 P$(  r  S " `}   r  S X> `  H  0޽h ? ___f3̙;/f980___PPT10.}V$  0 `$(  r  S } `}   r  S \ `  H  0޽h ? ___f3̙;/f980___PPT10.~@N$  0 p$(  r  S ` `}   r  S H `  H  0޽h ? ___f3̙;/f980___PPT10.@uV$  0 $$(  $r $ S [G `}  G r $ S G ` G H $ 0޽h ? ___f3̙;/f980___PPT10.H:$ " 0 PT$(  Tr T S Ԥ: `}  ~ r T S x: ` ~ H T 0޽h ? ___f3̙;/f980___PPT10.VK$  0 ,$(  ,r , S uw `}  w r , S xw ` w H , 0޽h ? ___f3̙;/f980___PPT10.@n$  0 4$(  4r 4 S ̿J `}  J r 4 S `J ` J H 4 0޽h ? ___f3̙;/f980___PPT10.X[$  0 8$(  8r 8 S J `}  J r 8 S \J ` J H 8 0޽h ? ___f3̙;/f980___PPT10.С$   0 @$(  @r @ S J `}  J r @ S 4J ` J H @ 0޽h ? ___f3̙;/f980___PPT10.P $  0 D$(  Dr D S : `}  : r D S  : ` : H D 0޽h ? ___f3̙;/f980___PPT10.\#%$ ! 0 0L$(  Lr L S \~ `}  ~ r L S ~ ` ~ H L 0޽h ? ___f3̙;/f980___PPT10.p.  0  H>(  H^ H S D(K   g H c $gD 0)  g 4 Issued before 3-year expiration rule for temp regs (Sec. 7805) BASICS  categorize interest expense by tracing to the type of expenditure made with the debt proceeds EX  loan used to pay for vacation = personal expenditure so produces personal interest Some special rules apply for debt proceeds rec d in cash or deposited into account which allow for some planning  discuss in later slide Asset securing the debt (if any) is NOT relevant, UNLESS that asset is the taxpayer s PR or second residence (-8T(m)(3)) or perhaps a tax-exempt investment Also applies to debt incurred before TRA 86 Retrace when use of the debt proceeds changes EX  borrow to buy computer for personal use = personal interest. Later sell computer and use proceeds to buy stock = investment interest H H 0޽h ? 3380___PPT10.R0CL  0 0L\(  L^ L S D(K   g L c $@hD 0)  g R TRA 86 added several new limitations on an individual s ability to deduct interest expense. In order to properly apply the limitations, an individual must first classify all of his interest expense. The regulations at 1.163-8T, along with some Notices that modify a few of the rules in these regs, provide the necessary rules. These are referred as the interest tracing rules. If interest expense is properly classified as qualified residence interest under 164(h)(3), it is not subject to the tracing rules (1.164-8T(m)(3)). In addition, application of the tracing rules does not lead automatically to deduction even if it is T or B interest. Certain rules override 163. For example, though debt proceeds may be traced to business expenses, if 263A(f) requires that interest to be capitalized, it must be capitalized rather than currently expensed as a trade or business expense. Similarly, though debt may be traced to the purchase of an investment, if the debt is secured by tax-exempt securities, the interest may be non-deductible under 265 and Rev Proc 72-18. Categories noted in 1.163-8T regs:  (A) Interest expense allocated to a trade or business expenditure (as defined in paragraph (b)(7) of this section) is taken into account under section 163 (h)(2)(A): (B) Interest expense allocated to a passive activity expenditure (as defined in paragraph (b)(4) of this section) or a former passive activity expenditure (as defined in paragraph (b)(2) of this section) is taken into account for purposes of section 469 in determining the income or loss from the activity to which such expenditure relates; (C) Interest expense allocated to an investment expenditure (as defined in paragraph (b)(3) of this section) is treated for purposes of section 163(d) as investment interest; (D) Interest expense allocated to a personal expenditure (as defined in paragraph (b)(5) of this section) is treated for purposes of section 163(h) as personal interest; and (E) Interest expense allocated to a portfolio expenditure (as defined in paragraph (b)(6) of this section) is treated for purposes of section 469(e)(2)(B)(ii) as interest expense described in section 469(e)(1)(A)(i)(III). P H L 0޽h ? 3380___PPT10.Rn  0   @P (  P^ P S D(K   h P c $+hD 0)  h .To have interest expense, must have valid debt. - person must be legally obligated to repay. - both parties expense repayment  they treat it as debt SEE MY TYPED NOTES &  A loan is generally not taxable income because the receipt of the loan is offset by the obligation to repay the loan. Comm'r v. Tufts, 461 U.S. 300, 307 (1983). For this rule to apply, however, the loan must be an  existing, unconditional, and legally enforceable obligation for the payment of a principal sum. Noguchi v. Comm'r, 992 F.2d 226, 227 [71 AFTR 2d 93-1557] (9th Cir. 1993); see also Geftman v. Comm'r, 154 F.3d 61, 68 [82 AFTR 2d 98-5617] (3d Cir. 1998) (requiring  an unconditional obligation on the part of the transferee to repay the money, and an unconditional intention on the part of the transferor to secure repayment ) (citation and internal quotation marks omitted). Whether a transaction is a loan for federal income tax purposes is ultimately a question of federal law. [MILENBACH, ET AL. v. COMM., 91 AFTR 2d 2003-818, 318 F.3d 924 (9th Cir.)]H':H P 0޽h ? 3380___PPT10.TbZ 0 PTj(  T^ T S D(K   h T c $IhD 0)  h `LIssue does come up. EX  PLR 200029018  Homeowner Association borrowed money to demolish and rebuild part of the common areas. T is an individual who is a homeowner and a member of the Association. T wanted to know if he could deduct any of the interest paid by the Association. The common areas were used as security on the debt. T s home was not collateral. IRS said no.  It is well established that the person entitled to deduct interest is the person who is legally liable to pay the interest. Association is a separate legal entity that cannot be ignored (per Moline Properties, 319 US 436 (1943)  a case covered in 223A). Association is borrower and party liable to repay. T has no personal obligation to repay + T s residence is not security for the loan so it cannot be QRI under 163(h)H T 0޽h ? 3380___PPT10.Tf  0 ~p\(  \^ \ S D(K   hx \ c $|NhD 0)  h H \ 0޽h ? 3380___PPT10.`u   0 "  d(  d^ d S D(K   h d c $\lhD 0)T  h<4___PPT9 dPersonal Personal per TRA 86 legislative history, Announcement 86-108, 1.163-9T(b)(2)(i)(A) and Redlark case (141 F3d 936 (9th Cir., 1998)). Similar result if 1040 deficiency was due to error on S corp of which taxpayer is a shareholder. Personal  not a T or B expense per 1.163-8T(b)(7) and Leg history (BB pg 266   Personal interest is any interest, other than interest incurred or continued in connection with the conduct of a trade or business (other than the trade or business of performing services as an employee), investment interest, or interest taken into account in computing the taxpayer s income or loss from passive activities for the year. Same as prior example. A partner is not an employee so apparently could treat as T or B (assuming is MP in the partnership s T or B) Investment interest per -8T(c)(4)(i)  need not generate interest income to be investment int debt<|" aH d 0޽h ? 3380___PPT10.`  0 f^l(  l^ l S D(K   hX l c $gD 0)  h Will go over how above is addressed in -8T regs as modified by some Notices. Rules are also summarized simply in some IRS Publications  see 225K website (such as Pub 535 on business expenses) Need to watch for when someday the -8T regs are finalized  will any changes be made? Will the Notices be fully incorporated? Might IRS decide that changes are needed and start again with proposed regs? At that point, any new temp regs would be subject to the 3-year expiration rule of Sec 7805H l 0޽h ? 3380___PPT10.cp?> 0 tN(  t^ t S D(K   h t c $hhD 0)  h D0EX of last point  if debt used to buy a personal car  Personal. Borrower CANNOT get a better result by not paying any interest until he sells the car and purchases stock. Interest that accrues while debt used for the car = personal. Where interest compounds  interest on the interest is allocated the same as the interest on the principal. Exception  a simplified method is available for when the use of the debt proceeds changes. May allocate based on straight-line basis. EX (1) at -8T(c)(2)(iii) - IRS trying to make simple.H t 0޽h ? 3380___PPT10.c k 0 |{(  |^ | S D(K   h | c $hD 0)  h q]Looking at borrowing these ways makes it easier to understand and apply the -8T tracing rulesH | 0޽h ? 3380___PPT10.dN1 0  A(  ^  S D(K   h  c $ hD 0)  h 7#Be sure to follow along in the regsH  0޽h ? 3380___PPT10.dѕ  0   0 (  ^  S D(K   h   c $hD 0)  h | N89-35  says taxpayers may rely on rule of the Notice wrt debt proceeds received in cash or deposited in an account after 12/31/87 and on or before the date on which further guidance is published. As of January 2010, no further guidance published. In FSA 200011025, one of the issues was whether Section VI of N 89-35 which modified the  single account and 15-day rules of -8T(c)(3) was still in effect during 1994. Answer was  yes . Citator does not indicate any modification to N89-35 and -8T has not been modified. Pub 535 on Business Expenses (see 225K website) explains the 3- day rule and single account rule  so apparently, all still valid. DON T be surprised if fellow practitioners are not aware of this. Notices that modify regs can easily be overlooked unless the commercial tool leads the research specifically to them. Note - -8T(c)(5)(ii)  if B does not use 30 day rule than must treat interest on cash borrowing as personal. Appears to be an anti-abuse rule because is difficult to trace what cash was sued for, so IRS assumes that if don t fall under and apply 30-day optional rule, then must have used the cash for personal exp. This presumptive rule is n/a to a corporate borrowerH  0޽h ? 3380___PPT10.hw& 0   p6 (  ^  S D(K   h   c $hD 0)  h ,  Applying general rule: Debt A used first, therefore treat as used for personal expenditure Debt B used $300 personal + $200 PA Debt C used $800 investment exp + $200 personal 15 day rule n/a here because no other exp made within 15 days of deposit of debt proceeds into account. Per -8T(c)(4)(vi)  rules at (c)(4) are to be applied separately to each account of the taxpayer. Thus, cannot look to see if T had any expenditure from somewhere else that he could say debt proceeds were used for. How does N 89-35 modify the 15 day and single account rules?  it modifies both  read VI of N89-35 towards the middle   In the case of debt proceeds deposited in an account, taxpayers may treat any expenditure made from any account of the t/p, or from cash, within 30 days before or 30 days after debt proceeds are deposited in any account of the t/p as made from such proceeds to the extent thereof. Fairly broad. Application to above example: Key  30 day rule is elective  use it if will provide T with more optimal interest categorization - ask T what other expenditure he made (that were not debt-financed) 30 days before 1/10 and 30 days after 1/10 to see if was something other than persona. Assume T bought stick fro $700 on 1/25. T should then elect to treat the Debt A proceeds as used for the stock purchase. Note that this stock could have been purchased by T s broker selling stock and buying new stock  ask T and look at all accounts and brokerage statement in order to avoid personal interest. 4Z9-ZZ H  0޽h ? 3380___PPT10.k  0 $(  ^  S D(K   h  c $hD 0)  h Logic  treat money as fungible + perhaps some flexibility to prevent taxpayers from making odd arguments that really wrote check 295 before check 294 or mailed it before Reasonable time  upon audit, IRS can determine when a check was deposited by the payee  look at when ck stamped or ck online records. Writing an earlier date on a check or register is ineffective  and unethical!H  0޽h ? 3380___PPT10.qP^ 0 n(  ^  S D(K   h  c $hD 0)  h d1st  is any of the debt secured by PR or second home? 2nd  ask what type of expenditures she had 30 days before and after the borrowing date to see if can get better categorization than the personal she would have for the credit cards and tuition. Perhaps she can even get better than PA for the p/s investment. Be sure to also ck brokerage statements - she may have been buying and selling stock with sale proceeds. 3rd  if debt is allocated to the p/s, need to know the asset mix of the p/s  discuss later 4th  if tuition was for higher ed  should see if Sec 221 would apply (there are definitional and MAGI limitations)Zx5m[rH  0޽h ? 3380___PPT10.r, 0 nf(  ^  S D(K   h`  c $dgD 0)  h See Ex at -8T(c)(6)(iii)(B) Be sure not to overlook this rule. EX  borrow $30,000, including $2,000 borrowing costs so that B nets $28,000. However, needs to trace use of $30,000. If $14,000 used for personal and $14,000 used for investment, treat the $2,000 borrowing costs as for personal and for investment. Thus, of interest  personal and = investment.H  0޽h ? 3380___PPT10.rp8 0 (  ^  S D(K   h  c $|gD 0)  h Note  this is a taxpayer favorable rule! Remember  for continuous borrowings, such as a line of credit, if borrowings are at different interest rates, then are separate debts. Partial debt repayments are treated as repaid per the order prescribed in the debt instrument. Recordkeeping burden! See examples in regsH  0޽h ? 3380___PPT10.s J 0  Z(  ^  S D(K   i  c $iD 0)  i P<Add l guidance is needed on hot to coordinate -8T with QRI rules. EX  T borrowed $120,000 as home equity debt. Under 163(h) limit, only $100,000 = QRI. When repays first $20,000, presumable, would be non-QRI portion. Any other rule would still allow T to treat up to $100,000 as QRI.H  0޽h ? 3380___PPT10.s 0 @(  ^  S D(K   i   c $iD 0)  i l-8T(j)(1)(iv)  treatment of accounts  debt allocated to an account (such as checking acct) is treated as allocated to an expenditure properly chargeable to capital account with respect to an asset. Thus, under general rule noted here, any expenditure from the account will usually require a recategorization of the interest expense (unless another investment expenditure is made). -8T(j)(1)(iii)  treatment of loan made by T  if T used debt proceeds to make a loan to someone else, such loan is treated as an exp properly chargeable to capital accent wrt an asset. When T collects on his loan, is treated as a disposition of the asset. EX  Jane borrows $5,000 and loans $4,000 of it to her ER. Jane is treated as making an investment exp with $4,000 of it because has created an interest producing asset. When ER repays the $4,000 to Jane, if Jane uses the money to pay for her wedding, interest from that date is treated as personal  treated as if Jane replaced an investment exp with a personal one. -8T(j)(1)(ii)  limitation on amount reallocated  amount of debt reallocated may not exceed proceeds from the disposition of the asset. Also, the amount of debt reallocated may not exceed the FMV of the asset on the date of change in use. EX  in 205, A borrowed $6,000 to acquire a computer to use in her Sch C consulting business. In 2008, when loan balance was $3,000, A sold the computer, but did not pay off the loan. A used the $2,000 proceeds from the sale for a personal vacation. Reallocation is needed because A has disposed of a debt-financed asset and did not pay off the debt with the proceeds Limitation  reallocation may not exceed the proceeds from the disposition. Therefore, $2,000 of the original debt is reallocated from a T or B exp to a personal exp. The remaining $1,000 of the debt is not reallocated, remains as producing T or B interest expense. NOTE  if A had sold the computer because was getting rid of his Sch C business, how would he continue to report the int on $1,000 of the debt? Would he continue to file a Sch C showing just int on the $1,000 debt? If yes, might raise red flat to IRS. IRS is aware of this problem and might provide a solution in final regs  whenever that is!! Q  does the 3- day rule apply to the proceeds from the sale of a debt-financed asset such as A s computer? -8T(j)  debt allocated to cap exp  reallocate to another exp at earlier of (a) date disposition proceeds are used for another exp, or (b) date character of first exp changes. -8T(j)(1)(iv)  if take disposition proceeds and deposit into account, deemed to be an investment exp and properly chargeable to a capital account and any exp from account equivalent to disposition of an asset -8T(j)(4) EX 91)  READ: (c)(4)(iii)(B)  15 day rule applies, therefore, 30 day rule should also apply. THEREFORE, in above example, instead of saying $2,000 of proceeds used for personal exp, look at exp 30 days before and after receipt of proceeds. Deferred payment sales (installment sales) - -8T(j)(3)  if A receives $1,000 at date of sale and expects the remaining $2,000 over next 2 years, that $2,000 (which is a debt allocated asset) is treated as allocated to an investment ex. See examples at (j)(3) P H  0޽h ? 3380___PPT10.tPV1E 0 XP`(  ^  S D(K   iJ  c $0!iD 0)  i -8T(d) on repayments $14,000 personal exp and $1,000 passive activity Q  what if B had borrowed the $15,000 to repay part of the $20,000 debt? A  should be able to apply the 30 day rule to the $15,000 to optimize its label. N89-35 is very broad  30 day rules applies to ANY account. However, is not entirely clear whether debt repayment and debt refinancing rule override the 30 day ordering rule  probably do not. If B had come to you for advice before borrowing any money, you could have helped B avoid any personal interest. B should have used Sch C receipts to pay off the $14,000 of personal debt and then borrowed add l money to use in the Sch C business  then entire $20,000 would have been traced to T or B expenditures.H  0޽h ? 3380___PPT10.wЌAR 0 b(  ^  S D(K   i  c $^iD 0)  i XDFirst  debt-financed acquisitions of interest in pass-through entities: N89-35  note that 2 terms are used:  contributions where owner borrows from 3P to contribute to entity  Purchases of interest where owner borrows from entity, thus, is no cash actually used see next slideH  0޽h ? 3380___PPT10.x  0 | t  (  ^  S D(K   in   c $$oiD 0)  i   Add l guidance  N 89-37 has guidance on how to categorize interest of a debt-financed acquisition of a passthru entity once it has been allocated per N 89-35 EX  Abby borrowed $20,000 from her mother to invest in a ltd p/s. P owns both an apt building and fair-sized investment portfolio. How should Abby categorize the int expense on this loan? Is a  contribution therefore, use any reasonable method to categorize. For example could trace to what p/s did with the money or allocate it based on p/s asset mix, IF Abby can get that info. That is a problem because K-1 has no balance sheet. Problem with the rules in the chart  IRS did not also provide any rule to ensure that T could get the info from the passthrough entity. Is some guidance out there, such as PLR 9116008 where t/p suggested what he thought were  reasonable methods for categorizing interest expense and IRS agreed. Where trying to better understand the Notices, ck for PLRs and TAMs Policy  why not have a de minimis rule? For example, would be simpler if rule was that if 80% or more of assets of passthru are in same category  business, PA or investment, owner may categorize all of his int on the debt to acquire an interest in the entity based on that one category.ZH  0޽h ? 3380___PPT10.x& 0 6(  ^  S D(K   i  c $iD 0)  i ,Prior to TRA86, was a more complicated question. Had to look at what real motive was for William buying stock  as EE or s/h. If there was any investment motive, likely to be classified as inv int expense. After TRA86, motive is not relevant. EX  TAM 9307005 notes this. Classify above based on -8T as modified by N89-35 depending on whether is a  contribution or  purchase of an interest H  0޽h ? 3380___PPT10.yp>- 0 ~(  ^  S D(K   ix  c $@iD 0)  i H  0޽h ? 3380___PPT10.{pe> 0 ~(  ^  S D(K   ix  c $iD 0)  i H  0޽h ? 3380___PPT10.{- 0 ~(  ^  S D(K   x  c $p9D 0)   H  0޽h ? 3380___PPT10.{@Hp 0 ~ (  ^  S D(K   x  c $ eD 0)   H  0޽h ? 3380___PPT10.{P7 0 ~0 (   ^   S D(K   x   c $0D 0)   H   0޽h ? 3380___PPT10.{p8־  0   @ (  ^  S D(K      c $iD 0)f  NF___PPT9(   B Per Notice 89-35  2 choices: PQ chose to say that $110,000 of debt used for operations and interest on balance of debt must be classified based on how partners used it. Q  could p/s allocate debt proceeds to depr exp and other non-cash exp? N 89-35 is silent; logically, would make no sense to do so treat all as debt-financed distribution. Per N88-37, report as  other deduction on K-1 When PQ pays down principal, per 89-35, PQ may treat as first paying ptr distribution. Tell partner that ___% of their debt has been repaid so they can figure out their int exp categorization. Theoretically, per -8T, if partner used debt proceeds for both personal and investment int expenditure, when PQ pays part of principal, partner is treated as paying down personal debt first per -8T debt repayment rule. Q  what if after the debt-financed distribution, a ptr sells his p/s interest. How will acquiring ptr treat any int exp shown as other ded on K-1 when ptr did not make any use of the debt proceeds because did not receive any? Possibly just thro in with other p/s expenditures on line 1, 2 or 3  wait for guidance.BZn" Z" ZIH  0޽h ? 3380___PPT10.}pö3^" 0  n(   ^   S D(K      c $vD 0)   dPub 535   Interest paid with funds borrowed from original lender. If you use the cash method of accounting, you cannot deduct interest you pay with funds borrowed from the original lender through a second loan, an advance, or any other arrangement similar to a loan. You can deduct the interest expense once you start making payments on the new loan. When you make a payment on the new loan, you first apply the payment to interest and then to the principal. All amounts you apply to the interest on the first loan are deductible, along with any interest you pay on the second loan, subject to any limits that apply. pm 'lH   0޽h ? 3380___PPT10.Df# 0 (v(  (^ ( S D(K    ( c $D 0)   lXNote  TRA 86 had limited restrictions on QRI. The existing rules with the AI and HEI limits came about with Revenue Act of 1987 Examples  credit card debt, debt above the AI and HEI limits that is not traced to any other deductible category, school tuition (although higher ed may fall under 221)H ( 0޽h ? 3380___PPT10.5 $ 0 , $ 0 (  0^ 0 S D(K   w  0 c $YwD 0)  w Tightened up by TRA 86 such that can only deduct to extent of NII, but unlimited c/f period remained Inv int expense is not PA interest expense. N 89-36 allowed limited election to treat inv int c/f from before 1987 as passive activity int expense. No longer available, but may have client with the c/f still Property held for investment defined in 163(d). Includes  any interest held by a taxpayer in an activity involving the conduct of a trade or business (I) which is not a passive activity, and (II) with respect to which the taxpayer does not materially participate. Examples  stock, bank/savings accounts, 280A(c)(5) residence rental if it is a T or B and t/p does not MP Rev Rul 93-68  individual borrowed money to buy stock to protect his employment with the corporation. IRS ruled was inv int expense. Stock generally produces dividend income. Motive for acquiring is NOT relevant. Note  t/p election to treat certain cap gain income in  investment income  doing so allows more of the inv int expense to be used currently, but then gets taxed at higher rateBZBH 0 0޽h ? 3380___PPT10.rY& 0 <i(  <^ < S D(K   J < c $JD 0)  J _KGo through this example using Form 4952 on your own + read the instructionsH < 0޽h ? 3380___PPT10.@ r' 0 VN H(  H^ H S D(K   :H H c ${:D 0)  : Rationale  per RP 72-18   Section 265(2) of the Code is derived from section 1201(1) of the Revenue Act of 1917 and section 234(a)(2) of the Revenue Act of 1918. It is clear from the legislative history of those sections and of subsequent unsuccessful efforts to amend such sections (or their successors) that Congress intended to disallow interest under section 265(2) of the Code only upon a showing of a purpose by the taxpayer to use borrowed funds to purchase or carry tax-exempt securities. See, e.g., H. Rept. 767, 65th Cong., 10; S. Rept. 617, 65th Cong., 6, 7 (1918); 65 Cong. Rec. 7541-7542 (1924); and 67 Cong. Rec. 2964 (1925). RP 72-18  guidance on how to determine if debt is to carry TE obligations$H H 0޽h ? 3380___PPT10.Ap') 0 @P7(  P^ P S D(K   ~ P c $:D 0)  ~ -Subsequent lessons on QRIH P 0޽h ? 3380___PPT10.@AE * 0   `X (  X^ X S D(K   ~|  X c $l:D 0)  ~  Examples from regs on relevance of who can claim dependent and who is legally liable on the loan. 1.221.1(b)  Examples. The following examples illustrate the rules of this paragraph (b)(2): Example (1). Student not claimed as dependent. Student B pays $750 of interest on qualified education loans during 2003. Student B's parents are not allowed a deduction for her as a dependent for 2003. Assuming fulfillment of all other relevant requirements, Student B may deduct under section 221 the $750 of interest paid in 2003. Example (2). Student claimed as dependent. Student C pays $750 of interest on qualified education loans during 2003. Only Student C has the legal obligation to make the payments. Student C's parent claims him as a dependent and is allowed a deduction under section 151 with respect to Student C in computing the parent's 2003 Federal income tax. Student C is not entitled to a deduction under section 221 for the $750 of interest paid in 2003. Because Student C's parent was not legally obligated to make the payments, Student C's parent also is not entitled to a deduction for the interest. 6`@DH X 0޽h ? 3380___PPT10.5W-rL w<GQ[e"q/zAy31eغ_/ 294e68:SI<1+?WA C UW%ZA\=*K,Y.g0u24m^@`dGKgIiukVbmoY`cs %nR o(   6Oh+'0 hp   $ 0<D0Interest Expense Limitations for IndividualsAnnette NellenEdgeAnnette Nellen28Microsoft Office PowerPoint@02@@L Ghg  ,T%&" WMFCy <8ܜ<1 """)))UUUMMMBBB999|PP3f333f3333f3ffffff3f̙3ff333f333333333f33333333f33f3ff3f3f3f3333f33̙33333f333333f3333f3ffffff3f33ff3f3f3f3fff3ffffffffff3ffff̙fff3fffff3fff333f3f3ff3ff33f̙̙3̙ff̙̙̙3f̙3f333f3333f3ffffff3f̙3f3f3f333f3333f3ffffff3f̙3f3ffffffffff!___www0  MO ??l(Kx(xKʦ """)))UUUMMMBBB999|PP3f3333f333ff3fffff3f3f̙f3333f3333333333f3333333f3f33ff3f3f3f3333f3333333f3̙33333f333ff3ffffff3f33f3ff3f3f3ffff3fffffffff3fffffff3f̙ffff3ff333f3ff33fff33f3ff̙3f3f3333f333ff3fffff̙̙3̙f̙̙̙3f̙3f3f3333f333ff3fffff3f3f̙3ffffffffff!___www&" WMFC <?@ABCDEFGHIJKLMNOPQRSTUV,2$*hrsz`C 0AA@8,ʚ;ʚ;g4YdYdg+O 0lppp@ <4ddddv 0 1+ g4FdFd8i+O 0pp pp0___PPT10 ___PPT9d\ ?  %O  =,Interest Expense Limitations for Individuals TopicsBWhat is interest expense? General overview to interest expense limitations and their rationale Basics of interest tracing rules of Reg. 1.163-8T and related Notices Limitations: Personal interest Interest on education loans (IRC 221) Investment interest + interest related to tax-exempt activities Home mortgage interest.ZZXInterest expense  pre-classification issues--&Possible tax issues: Is a prepayment penalty interest? If a closely-held corporation loans money to a shareholder/employee, is it a bona fide debt that could produce interest expense or is it a distribution or compensation? Debt v equity Non-recourse debt might warrant greater scrutiny (EX  Rev Rul 77-110) Is market interest being charged and if not, must interest be imputed?*ZgZg-I What is debt?4Naguchi, 992 F2d 226 (9th Cir. 1993)   To be deductible under section 163(a), the obligation on which interest is based must be an "existing, unconditional and legally enforceable obligation for the payment of a principal sum." Howlett v. Commissioner, 56 T.C. 951, 960 (1971). A debt must be an existing and genuine obligation in order to give rise to deductible interest payments. As we explained in Estate of Franklin v. Commissioner, 544 F.2d 1045, 1049 (9th Cir. 1976), "a mere chance that a genuine debt obligation may arise ... is not enough to justify an interest deduction. To justify the deduction the debt must exist; potential existence will not do.  dZ "  0 0 ;AWG Leasing Trust v. U.S., 592 F Supp 2d 953 (ND Oh, 2008)  <&"& The Supreme Court has generally defined  interest as  compensation for the use or forbearance of money. See, e.g., Comm'r v. Nat'l Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 145 (1974) (internal citation omitted). In order for a taxpayer to take such a deduction, however, the underlying debt on which the interest is paid must be genuine. Bridges v. Comm'r, 325 F.2d 180, 184 (4th Cir. 1963). See also Goldstein v. Comm'r, 364 F.2d 734, 742 (2nd Cir. 1966), cert. denied, 385 U.S. 1005 (1967) (holding  Section 163(a) does not  intend that taxpayers should be permitted deductions for interest paid on debts that were entered into solely in order to obtain a deduction ). In deciding whether economic advances made to a corporation are true debt, courts must consider  whether the objective facts establish an intention to create an unconditional obligation to repay the advances. Indmar Products Co. v. Comm'r, 444 F.3d 771, 776 (6th Cir. 2006) (citing Roth Steel Tube Co. v. Comm'r, 800 F.2d 625, 630 (6th Cir. 1986). Pk<&' -(  !"#$%&'()*+,-./0123456789:;<=>?@ABCDEFGHIJKLMNOPQRSTUVWXYZ[\]^_`abcdefghijklmnopqrstuvwxyz{|}~      !"#$%&'()*+,-./0123456789:;<=>?@ABCEFGHIJKLMNOPQRSTUVWXYZ[\]^_`abcdefghijklmnopqrstuvwxyz{|}~7Root EntrydO)АL1@ PicturesCCurrent User+JSummaryInformation(DPowerPoint Document( ,3DocumentSummaryInformation8 J/getDoc?DocID=T0AFTRF:36540.1&pinpnt=https://checkpoint.riag.com/getDoc?DocID=T0AFTRF:36540.1&pinpnt= N/getDoc?DocID=T0AFTRS57:38761.1&pinpnt=https://checkpoint.riag.com/getDoc?DocID=T0AFTRS57:38761.1&pinpnt= N/getDoc?DocID=T0AFTRS80:28151.1&pinpnt=https://checkpoint.riag.com/getDoc?DocID=T0AFTRS80:28151.1&pinpnt=/ 00DArialngsRoman01,O 0DGaramondRoman01,O 0 DTimes New Roman01,O 00DWingdingsRoman01,O 0@0.  @n?" dd@  @@`` TLXWQQ        !"#$%I'()*+,-./0123456789.;<=>?@ABCDEFGHIJKLMNOPQRSTUV,2$*hrsz`C 0AA@8,ʚ;ʚ;g4YdYdf,O 0lppp@ <4ddddv 0 1, g4FdFdhh,O 0pp pp0___PPT10 ___PPT9d\ ?  %O  =g,Interest Expense Limitations for Individuals TopicsBWhat is interest expense? General overview to interest expense limitations and their rationale Basics of interest tracing rules of Reg. 1.163-8T and related Notices Limitations: Personal interest Interest on education loans (IRC 221) Investment interest + interest related to tax-exempt activities Home mortgage interest.ZZXInterest expense  pre-classification issues--&Possible tax issues: Is a prepayment penalty interest? If a closely-held corporation loans money to a shareholder/employee, is it a bona fide debt that could produce interest expense or is it a distribution or compensation? Debt v equity Non-recourse debt might warrant greater scrutiny (EX  Rev Rul 7-110) Is market interest being charged and if not, must interest be imputed?*ZfZf What is debt?4Naguchi, 992 F2d 226 (9th Cir. 1993)   To be deductible under section 163(a), the obligation on which interest is based must be an "existing, unconditional and legally enforceable obligation for the payment of a principal sum." Howlett v. Commissioner, 56 T.C. 951, 960 (1971). A debt must be an existing and genuine obligation in order to give rise to deductible interest payments. As we explained in Estate of Franklin v. Commissioner, 544 F.2d 1045, 1049 (9th Cir. 1976), "a mere chance that a genuine debt obligation may arise ... is not enough to justify an interest deduction. To justify the deduction the debt must exist; potential existence will not do.  dZ "  0 0 ;AWG Leasing Trust v. U.S., 592 F Supp 2d 953 (ND Oh, 2008)  <&"& The Supreme Court has generally defined  interest as  compensation for the use or forbearance of money. See, e.g., Comm'r v. Nat'l Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 145 (1974) (internal citation omitted). In order for a taxpayer to take such a deduction, however, the underlying debt on which the interest is paid must be genuine. Bridges v. Comm'r, 325 F.2d 180, 184 (4th Cir. 1963). See also Goldstein v. Comm'r, 364 F.2d 734, 742 (2nd Cir. 1966), cert. denied, 385 U.S. 1005 (1967) (holding  Section 163(a) does not  intend that taxpayers should be permitted deductions for interest paid on debts that were entered into solely in order to obtain a deduction ). In deciding whether economic advances made to a corporation are true debt, courts must consider  whether the objective facts establish an intention to create an unconditional obligation to repay the advances. Indmar Products Co. v. Comm'r, 444 F.3d 771, 776 (6th Cir. 2006) (citing Roth Steel Tube Co. v. Comm'r, 800 F.2d 625, 630 (6th Cir. 1986). Pk<&' -(  0pq  0 0  0AWG - continuedX  The Sixth Circuit has embraced the Second Circuit's definition of  debt for tax purposes as: [A]n unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor's income or lack thereof. While some variation from this formula is not fatal to the taxpayer's effort to have the advance treated as a debt for tax purposes, ... too great a variation will of course preclude such treatment. The question becomes, then, what is  too great a variation ? Indmar Products, 444 F.3d at 776 (citing Gilbert v. Comm'r, 248 F.2d 399, 402 03 (2nd Cir. 1957) (internal quotation marks omitted). xP`PLP`N bc 0ac ,Who can potentially deduct interest expense?--&Assuming it falls into a deductible category & Generally, the person legally liable and who pays it Reg. 1.163-1(b)   Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness. &/E/E Clarification of 1.163-1(b)Golder, Jr., 604 F.2d 34 (9th Cir. 1979) Excerpt:  Taxpayers do not challenge the Tax Court's conclusion that they were not directly liable on the Rancho Vistoso indebtedness. Nor do they dispute that a deduction for interest under section 163 cannot ordinarily be taken unless the interest was owed on the indebtedness of the taxpayer. They argue, however, that Treasury Regulation section 1.163-1(b) creates an "exception" to this rule which would entitle them to deduct the payments they made as guarantors of the corporate obligation. Reg. section 1.163-1(b) provides: "Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness ...." Taxpayers argue that while it is the intention of section 163(a) to deny an interest deduction where the taxpayer's liability is secondary or indirect, Reg.1.163-1(b) creates an exception to this rule where the secondary liability is secured by a mortgage on the taxpayer's real estate. We do not agree. Reg. 1.163-1(b) must be read in its proper context, i.e. in light of its parent statute, section 163(a). Section 163(a) permits an interest deduction only on the taxpayer's own indebtedness. Reg. 1.163-1(b) does nothing more than permit the deduction of interest in situations where the taxpayer-borrower is not personally liable on a mortgage of property which is used as security for a loan made to the taxpayer. For example, a taxpayer purchases land paying part of the purchase price in cash and the balance with a non-recourse note secured by a mortgage on the land; there, in the event of default, the creditor may look only to the property. Although the taxpayer is not directly liable on the debt since the creditor may look only to the pledged property for repayment Reg. 1.163-1(b) permits the taxpayer to deduct interest payments since the default affects only the taxpayer and no one else. The taxpayer must pay the interest to avoid foreclosure of his ownership interest in the property. Thus Reg. 1.163-1(b) does not create an "exception" to the statutory rule of section 163(a) that interest is deductible only with respect to the indebtedness of the taxpayer, but simply recognizes the economic substance of non-recourse borrowing. Reg. 1.163-1(b) permits the taxpayer-borrower in such cases to deduct the interest on the loan even though the taxpayer is not personally liable on the loan. )PPPP         k 0 0rs  +Overview to individual interest limitations,,&Why needed: 469  to determine PAL, must know how much interest expense associated with the activity 163(d)  a limitation had been around even before TRA 86 After TRA 86 and new limitations for PAL and personal interest and home mortgage interest, needed to know what was investment interest and what was not To apply rule for disallowance of personal interest added by TRA 86N D D (Authority to issue interest tracing regsn469(l)(4)   Regulations. The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out provisions of this section, including regulations (4) which provide for the determination of the allocation of interest expense for purposes of this section General authority under 78056ll Interest tracing basicsReg. 1.163-8T (TD 8145; 7/1/87) Basic rule -8T(a)(3)   Manner of allocation. In general, interest expense on a debt is allocated in the same manner as the debt to which such interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures. This section prescribes rules for tracing debt proceeds to specific expenditures. &Z96 %What is included in interest expense?s1.163-8T(c)(2)(ii)(C): Relevant provisions of the loan agreement OID rules Unstated interest per 483, 1271 - 1275&]] FExamples  categorize the following~Interest on auto loan from Ford Motor Credit Corporation for personal auto. Interest assessed by IRS upon audit of last year s Schedule C. Interest on auto loan where car is used 60% for business, borrower is an employee Interest on Visa credit card where about 50% of each bill is for employee business expenses Same as (4) but borrower is an active partner in a partnership Loan proceeds are deposited in a non-interest bearing checking account.nP #Mechanics of Interest Tracing RulesSomewhat complex and detailed. Special rules provided for: How the money was rec d (in cash, in an account, seller-financing (no proceeds rec d)) Special  pretend rules  15-day one in regs supplemented by 30-day rule in Notices Repayment ordering rules Change in loan proceeds rules More funds deposited into an account Refinancing Passthrough entities*;(;(Allocation period of -8T(c)(2)Begins on date proceeds used or treated as used to make an expenditure and ends on earlier of date debt is repaid or reallocated to a different expenditure Start includes when the proceeds are sitting in borrower s account. Label the interest expense based on how debt proceeds used. Does not matter if taxpayer pays interest late when the debt has been reallocated to a different use*eeWays of borrowing moneyLender keeps the proceeds (seller financing) -8T(c)(3) Borrower received in cash -8T(c)(5) Funds deposited into borrower s account -8T(c)(4)t-  ( -  ( 'Debt proceeds not disbursed to borrower((&-8T(c)(3) Categorize by treating as if borrower did receive funds and used them EX  buy rental property and assume the debt on it. Assuming is a passive activity, have passive activity debt and interest expense Is no 15-day rule (or 30-day rule) applicable6P.P.!Debt proceeds distributed in cashb-8T(c)(5)  generally, trace to use, otherwise, interest is assumed to be personal 15-day  pretend rule  B may treat any cash expenditure made within 15 days of receiving the cash as made from the debt proceeds Notice 89-35 modifies the 15-day rule to a 30-day before or after rule EX  B borrows $30,000 in cash on 5/1/08 and uses it to pay personal bills on 5/1. B should look to any other cash expenditure made between 4/1/08 and 5/31/08 that would produce deductible interest and  pretend that the cash was really used for that expenditure. Document it!BPGPPG"LDebt deposited into borrower s account''&-8T(c)(4) Deposit into account = investment expenditure Reallocate when debt proceeds used for another expenditure What if the account also has non-borrowed funds  which is presumed used first? -8T(c)(4)(ii)  debt proceeds treated as used before unborrowed funds and before any amounts deposited after the debt proceeds are deposited. 2 exceptions to general ordering rule: (1)  if account only has loan proceeds and interest income from the debt  may treat expenditures as from the interest income -8T(c)(4)(iii)(C) (2) 15 day rule which is modified to 30 day before and after rule by N89-35^sPPPPPsP  #*Example from -8T(c)(4) modified for N89-35++&%Additional rules for debt proceeds deposited into borrower s accountEE&V-8T(c)(4)(iii)  multiple checks written on same day  treat as written in any order -8T(c)(3)(iii)  expenditure from checking account is treated as made when check written, provided check is delivered or mailed to payee within a reasonable period after writing the check What is a reasonable time?&&^More rules for funds deposited into B s account00&-8T(c)(4)(iv)  optional method for determining date of reallocation B may treat all expenditure made during any month from debt proceeds as occurring on later of: 1st day of the month, or Date on which debt proceeds deposited in the account Benefit  may calculate interest for the entire month, rather than treat change in use of debt proceeds as occurring during the month -8T(c)(4)(v)  simultaneous deposits  if 2 or more debt deposited into account at same time, treat as deposited in order debts were incurred. If truly simultaneously created, then B may chose which was incurred first. Debt on which interest accrues at different rates are treated as separate debt. For example, line of credit with fluctuating interest rate. If draw on credit on Feb 1 at 7% rate and draw again on April 1 at 7/5% rate, have 2 different debts.EP_PNPPPE_ K  (QuestionTZena borrowed $40,000 and used it as follows (it was deposited into her checking account): $10,000 to pay off credit cards $10,000 to pay tuition for 7th grade daughter $20,000 to invest in Garden Villa Apts Ltd Partnership What type of the interest expense does Zena have and what information to you need from her to answer this question?R[t[< Ht*=Debt proceeds used to pay borrowing costs or interest expense>>&"-8T(c)(6)(ii) & (iii) If debt proceeds used to pay interest on another debt  categorize the interest on 2nd debt same as on 1st debt If debt proceeds used to pay borrowing costs of a different debt  categorize interest same as on other debt. If debt proceeds used to pay borrowing costs of that same debt (borrowing costs were added to the debt balance)  categorize same as for balance of the debt.BZj  +Debt repayment-8T(d) If debt repaid was a multi-use debt, and only part of the principal was repaid, then apply following ordering rule to determine which  use of debt was repaid: Amounts allocated to personal expenditures Investment expenditures and passive activity (other than RRE-AP)  within this class, treat repayment as going towards whichever expenditure was made first. If made on same day, then taxpayer choice. RRE-AP Former passive activity expenditure Trade or business4Z0qZ0,Debt refinancings1-8T(e) If refinanced debt is only used to pay off part of the original debt, then apply the repayment ordering rules to determine character of interest expense, assuming original debt was a multi-use debt. If refinanced debt > original debt, categorize interest on excess debt under general tracing rules.0Reallocation of debt-8T(j) General rule: debt allocated to an expenditure chargeable to a capital account must be reallocated to another expenditure at earlier of: Date original asset is sold and proceeds are used for something else Date on which use of the asset changes, such as from business to personal&2QuestionLIn 2007, B borrowed $20,000 from her bank and used the proceeds to pay off $14000 of personal debts, $3,000 to buy a new computer for her Sch C business and the balance to invest in a ltd partnership which is a passive activity to her. In 2009, B makes first payment of principal, paying $15,000. What part of the debt has she paid?3Debt & Passthrough Entities-8T(f)  (i)   reserved IRS provided the rules in Notices N89-35 provides rules on how to categorize interest expense when: A) owner borrows to acquire interest in p/s or S corp B) p/s or S corp borrows and distributes debt proceeds to owners&~w~w6CDebt related to acq of interest in passthru entity per Notice 89-35DD&8QuestionWilliam is a shareholder in an S corp and is also an employee of the corporation. William borrowed $50K to acquire stock in the corp. Is the interest expense trade or business or investment interest expense?9LQuestion  p/s borrows and distributes''&Partnership PQ s property has greatly appreciated in value and there is no debt on it. General partner thinks it would be wise to borrow $500K against the property at 5% rate in order to make a distribution to the partners. PQ s normal operating expenses are about $110K per year. Explain to general partner how the interest expense is to be reported on partners K-1s and what he should tell the partners about categorizing their interest expense.; *Policy  why tracing?Could IRS have used an approach other than tracing for the -8T regs? Preamble to -8T regs notes that some taxpayers may attempt to manipulate the tracing rules and future regs might contain some anti-abuse or special rules Other approaches IRS could have considered: Pro rate allocation Problem  what base to use? If need to allocate based on FMV of borrower s assets, would require appraisals How debt is secured  Carrying an asset  similar to old prop reg at 1.57-2(b)(1)(iii)  similar to the interest capitalization rules where expenditures exceed traced debt  avoided cost methodvEZZZmZZEm<!"How are late fees on debt treated?|Was the fee paid for the use or forbearance of money? Yes  likely is interest No  see if is a T or B expense under 162 fyi Rev Rul 69-189, 71-98, 72-315, 73-136 Bailey, TC Memo 1991-385, aff d (11th Cir,1992)  struggling business incurred regular overdraft charges/fees; held not ordinary and necessary under 162j6ZDZZZ6DIuC"Borrowing from same lenderLQuery  has the borrower really paid anything? Arguably still in same position  owes $ to original lender Battlestein (5th Cir. 1980) Wilkerson (9t Cir. 1981) Also noted in IRS Pub 535 Exception where account where 2nd loan proceeds were deposited also had other funds: Burgess, 8 TC 47 (1947)/<OU/<?4 E#Personal interest expenseNon-deductible starting with TRA 86 Rationale: BB pg 263 Deductibility created incentive to borrow Also, because supported incentive to invest in consumer items rather than investments EX  tax law doesn t require reporting of imputed rental value of owner-occupied housing But kept home mortgage int deduction because of  important policy goal of home ownership Examples? Try to avoid via HEI (although are putting home at risk) and 30-day rule of the tracing rulesv9ZZYZZZhZ9YZ  hM*!221 Interest on education loans Added by TRA 97 Rationale:  many students incur considerable debt in the course of obtaining undergraduate and graduate education. The Committee believes that permitting a deduction for interest on certain student loans will help to ease the financial burden that such obligations represent. Several limitations: Overall: $2,500 Modified AGI limits Limits based on definition of  qualified education loan and  qualified higher education expenses No deduction if taken under some other provision@**F$Investment interest limitation2163(d) and Form 4952 Deduction      !"#$%&'()*+,-./2345689:;<=>?@ABCDEFGHIJKLMNOPQRSTUVWXYZ[\]^_`abcdefghijklmnopqrstuvwxyz{|}~ cannot exceed  net investment income NII = excess of investment income over investment expenses  Investment income =  the sum of (i) gross income from property held for investment (other than any gain taken into account under clause (ii)(I)), (ii) the excess (if any) of (I) the net gain attributable to the disposition of property held for investment, over (II) the net capital gain determined by only taking into account gains and losses from dispositions of property held for investment, plus (iii) so much of the net capital gain referred to in clause (ii)(II) (or, if lesser, the net gain referred to in clause (ii)(I)) as the taxpayer elects to take into account under this clause. Such term shall include qualified dividend income (as defined in section 1(h)(11)(B)) only to the extent the taxpayer elects to treat such income as investment income for purposes of this subsection. Amount not deductible in current year carries forward indefinitely subject to same limitation in subsequent yearsFPPPPrPFv`r    0 0Sc 0 0 3 0I%.Investment interest expense limitation example//&Mr. and Mrs. Smith have following for 2007. They prefer to have any income tax can be taxed at a lower rate treated that way. Sch B interest income $23,000 Qualified dividends $1,000 Int exp to acquire int in ltd partnership X (80% of assets are rental and 20% are portfolio) $3,000 Margin account interest $37,000 AGI $133,000 Investment expenses $2,500 Other misc itemized deductions $3,300PJ&AnswerInvestment income $23,000 Less: Inv expenses ( 2,500) NII $20,500 Inv int expense: Margin loan $37,000 P/S 600 ($3,000 x 20%) total $37,600 Excess to carryforward to 2008 $17,100 L^w. $E*K'Tax-exempt interest expense^265 1.163-8T(m)(2)(i)  generally,  any limitation on the deductibility of an item (other than the passive loss and nonbusiness interest limitations) applies without regard to the manner in which debt is allocated under this section. Thus, for example, interest expense treated under section 265(a)(2) as interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from Federal income tax is not deductible regardless of the expenditure to which the underlying debt is allocated under this section. 0Z0N(OHow to determine if interest expense is properly allocable to tax-exempt incomePP&Reg. 1.265-1(c)   Allocation of expenses to a class or classes of exempt income. Expenses and amounts otherwise allowable which are directly allocable to any class or classes of exempt income shall be allocated thereto; and expenses and amounts directly allocable to any class or classes of nonexempt income shall be allocated thereto. If an expense or amount otherwise allowable is indirectly allocable to both a class of nonexempt income and a class of exempt income, a reasonable proportion thereof determined in the light of all the facts and circumstances in each case shall be allocated to each. 1.163-1(d)  statement required to be included on tax return 1.163-10T(b)  QRI rules subject to 265(a). EX  borrow home equity loan and use of proceeds to purchase tax-exempt bonds then of interest expense is not deductibleDP}P>u}O)ReviewImportant to know type of interest expense an individual has Generally  apply tracing rules of 1.163-8T and Notices If secured by PR or second home  ck if QRI in which case tracing n/a Unless elect under 1.163-10T(o)(5) to treat as NOT secured by residence Planning possibilities Recordkeeping important to prove type of interest expense you have at all timesV=Z~ZHZgZ=~Hg/ ! $ ' ) -./1457:=>?@ABDGHLP Q!R"  0 ~ H(  H^ H S D(K   \x H c $(l\D 0)  \ H H 0޽h ? 3380___PPT10.R0C$  0 0L4(  L^ L S D(K   \ L c $L\D 0)  \ *P H L 0޽h ? 3380___PPT10.Rn 0 ~@P(  P^ P S D(K   \x P c $\D 0)  \ H P 0޽h ? 3380___PPT10.Tb 0 ~PT(  T^ T S D(K   \x T c $\D 0)  \ H T 0޽h ? 3380___PPT10.Tf  0 d(  d^ d S D(K   \ d c $L\D 0)T  \<4___PPT9 B" H d 0޽h ? 3380___PPT10.`  0 ~l(  l^ l S D(K   \x l c $8\D 0)  \ H l 0޽h ? 3380___PPT10.cp? 0 ~t(  t^ t S D(K   \x t c $\D 0)  \ H t 0޽h ? 3380___PPT10.c  0 ~|(  |^ | S D(K   \x | c $\D 0)  \ H | 0޽h ? 3380___PPT10.dN 0 ~ (  ^  S D(K   \x  c $\D 0)  \ H  0޽h ? 3380___PPT10.dѕ 0 ~0(  ^  S D(K   ]x  c $]D 0)  ] H  0޽h ? 3380___PPT10.hw$ 0 p4(  ^  S D(K   ]  c $]D 0)  ] *Z H  0޽h ? 3380___PPT10.k  0 ~(  ^  S D(K   ]x  c $@]D 0)  ] H  0޽h ? 3380___PPT10.qP 0 ~(  ^  S D(K   ]x  c $P]D 0)  ] H  0޽h ? 3380___PPT10.r, 0 ~(  ^  S D(K   ]x  c $_]D 0)  ] H  0޽h ? 3380___PPT10.rp8 0 ~(  ^  S D(K   ]x  c $`]D 0)  ] H  0޽h ? 3380___PPT10.s  0 ~ (  ^  S D(K   ]x  c $Xw]D 0)  ] H  0޽h ? 3380___PPT10.s$ 0 @4(  ^  S D(K   ]  c $]D 0)  ] *PH  0޽h ? 3380___PPT10.tPV1E 0 ~`(  ^  S D(K   ]x  c $]D 0)  ] H  0޽h ? 3380___PPT10.wЌA 0 ~(  ^  S D(K   ]x  c $]D 0)  ] H  0޽h ? 3380___PPT10.x" 0 2(  ^  S D(K   ]  c $P]D 0)  ] (ZH  0޽h ? 3380___PPT10.x 0 ~(  ^  S D(K   ]x  c $]D 0)  ] H  0޽h ? 3380___PPT10.yp>-8 0 @H(  ^  S D(K   _  c $H _D 0)  _ >ZH  0޽h ? 3380___PPT10.}pö3" 0 ~ (   ^   S D(K   _x   c $_D 0)  _ H   0޽h ? 3380___PPT10.D# 0 ~((  (^ ( S D(K   _x ( c $>_D 0)  _ H ( 0޽h ? 3380___PPT10.5"$ 0 02(  0^ 0 S D(K   _ 0 c $F_D 0)  _ (ZH 0 0޽h ? 3380___PPT10.r& 0 ~<(  <^ < S D(K   _x < c $@c_D 0)  _ H < 0޽h ? 3380___PPT10.@ r' 0 ~ H(  H^ H S D(K   _x H c $pi_D 0)  _ H H 0޽h ? 3380___PPT10.Ap) 0 ~@P(  P^ P S D(K   _x P c $|_D 0)  _ H P 0޽h ? 3380___PPT10.@AE* 0 ~`X(  X^ X S D(K   _x X c $_D 0)  _ H X 0޽h ? 3380___PPT10.5W-ro@1"3N5\7j9P;>@B*D$8F'dH)rJ-0LNP1R4 TV7X:[B*]Dj_G xacLeP0gik)s yomR (   9J/getDoc?DocID=T0AFTRF:36540.1&pinpnt=https://checkpoint.riag.com/getDoc?DocID=T0AFTRF:36540.1&pi  !"#$%&'()*,՜.+,D՜.+,<    On-screen Show,3+#' 0Arial GaramondTimes New Roman WingdingsEdge-Interest Expense Limitations for IndividualsTopics-Interest expense pre-classification issuesWhat is debt?<AWG Leasing Trust v. U.S., 592 F Supp 2d 953 (ND Oh, 2008) AWG - continued-Who can potentially deduct interest expense?Clarification of 1.163-1(b),Overview to individual interest limitations)Authority to issue interest tracing regsInterest tracing basics&What is included in interest expense?$Examples categorize the following$Mechanics of Interest Tracing RulesAllocation period of -8T(c)(2)Ways of borrowing money(Debt proceeds not disbursed to borrower"Debt proceeds distributed in cash'Debt deposited into borrowers account+Example from -8T(c)(4) modified for N89-35EAdditional rules for debt proceeds deposited into borrowers account0More rules for funds deposited into Bs account Question>Debt proceeds used to pay borrowing costs or interest expenseDebt repaymentDebt refinancingsReallocation of debt QuestionDebt & Passthrough EntitiesDDebt related to acq of interest in passthru entity per Notice 89-35 Question'Question p/s borrows and distributesPolicy why tracing?#How are late fees on debt treated?Borrowing from same lenderPersonal interest expense"221 Interest on education loans Investment interest limitation/Investment interest expense limitation exampleAnswerTax-exempt interest expensePHow to determine if interest expense is properly allocable to tax-exempt incomeReview  Fonts UsedDesign Template Slide Titles+| 8@ _PID_HLINKSA4Ahttps://checkpoint.riag.com/getDoc?DocID=T0AFTRF:36540.1&pinpnt=Chttps://checkpoint.riag.com/getDoc?DocID=T0AFTRS57:38761.1&pinpnt=Chttps://checkpoint.riag.com/getDoc?DocID=T0AFTRS80:28151.1&pinpnt=&_3Annette NellenAnnette Nellen  0pq  0 0  0AWG - continuedX  The Sixth Circuit has embraced the Second Circuit's definition of  debt for tax purposes as: [A]n unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor's income or lack thereof. While some variation from this formula is not fatal to the taxpayer's effort to have the advance treated as a debt for tax purposes, ... too great a variation will of course preclude such treatment. The question becomes, then, what is  too great a variation ? Indmar Products, 444 F.3d at 776 (citing Gilbert v. Comm'r, 248 F.2d 399, 402 03 (2nd Cir. 1957) (internal quotation marks omitted). xP`PLP`N bc 0ac ,Who can potentially deduct interest expense?--&Assuming it falls into a deductible category & Generally, the person legally liable and who pays it Reg. 1.163-1(b)   Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness. &/E/E Clarification of 1.163-1(b)Golder, Jr., 604 F.2d 34 (9th Cir. 1979) Excerpt:  Taxpayers do not challenge the Tax Court's conclusion that they were not directly liable on the Rancho Vistoso indebtedness. Nor do they dispute that a deduction for interest under section 163 cannot ordinarily be taken unless the interest was owed on the indebtedness of the taxpayer. They argue, however, that Treasury Regulation section 1.163-1(b) creates an "exception" to this rule which would entitle them to deduct the payments they made as guarantors of the corporate obligation. Reg. section 1.163-1(b) provides: "Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness ...." Taxpayers argue that while it is the intention of section 163(a) to deny an interest deduction where the taxpayer's liability is secondary or indirect, Reg.1.163-1(b) creates an exception to this rule where the secondary liability is secured by a mortgage on the taxpayer's real estate. We do not agree. Reg. 1.163-1(b) must be read in its proper context, i.e. in light of its parent statute, section 163(a). Section 163(a) permits an interest deduction only on the taxpayer's own indebtedness. Reg. 1.163-1(b) does nothing more than permit the deduction of interest in situations where the taxpayer-borrower is not personally liable on a mortgage of property which is used as security for a loan made to the taxpayer. For example, a taxpayer purchases land paying part of the purchase price in cash and the balance with a non-recourse note secured by a mortgage on the land; there, in the event of default, the creditor may look only to the property. Although the taxpayer is not directly liable on the debt since the creditor may look only to the pledged property for repayment Reg. 1.163-1(b) permits the taxpayer to deduct interest payments since the default affects only the taxpayer and no one else. The taxpayer must pay the interest to avoid foreclosure of his ownership interest in the property. Thus Reg. 1.163-1(b) does not create an "exception" to the statutory rule of section 163(a) that interest is deductible only with respect to the indebtedness of the taxpayer, but simply recognizes the economic substance of non-recourse borrowing. Reg. 1.163-1(b) permits the taxpayer-borrower in such cases to deduct the interest on the loan even though the taxpayer is not personally liable on the loan. )PPPP         k 0 0rs  +Overview to individual interest limitations,,&Why needed: 469  to determine PAL, must know how much interest expense associated with the activity 163(d)  a limitation had been around even before TRA 86 After TRA 86 and new limitations for PAL and personal interest and home mortgage interest, needed to know what was investment interest and what was not To apply rule for disallowance of personal interest added by TRA 86N D D (Authority to issue interest tracing regsn469(l)(4)   Regulations. The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out provisions of this section, including regulations (4) which provide for the determination of the allocation of interest expense for purposes of this section General authority under 78056ll Interest tracing basicsReg. 1.163-8T (TD 8145; 7/1/87) Basic rule -8T(a)(3)   Manner of allocation. In general, interest expense on a debt is allocated in the same manner as the debt to which such interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures. This section prescribes rules for tracing debt proceeds to specific expenditures. &Z96 %What is included in interest expense?s1.163-8T(c)(2)(ii)(C): Relevant provisions of the loan agreement OID rules Unstated interest per 483, 1271 - 1275&]] FExamples  categorize the following~Interest on auto loan from Ford Motor Credit Corporation for personal auto. Interest assessed by IRS upon audit of last year s Schedule C. Interest on auto loan where car is used 60% for business, borrower is an employee Interest on Visa credit card where about 50% of each bill is for employee business expenses Same as (4) but borrower is an active partner in a partnership Loan proceeds are deposited in a non-interest bearing checking account.nP #Mechanics of Interest Tracing RulesSomewhat complex and detailed. Special rules provided for: How the money was rec d (in cash, in an account, seller-financing (no proceeds rec d)) Special  pretend rules  15-day one in regs supplemented by 30-day rule in Notices Repayment ordering rules Change in loan proceeds rules More funds deposited into an account Refinancing Passthrough entities*;(;(Allocation period of -8T(c)(2)Begins on date proceeds used or treated as used to make an expenditure and ends on earlier of date debt is repaid or reallocated to a different expenditure Start includes when the proceeds are sitting in borrower s account. Label the interest expense based on how debt proceeds used. Does not matter if taxpayer pays interest late when the debt has been reallocated to a different use*eeWays of borrowing moneyLender keeps the proceeds (seller financing) -8T(c)(3) Borrower received in cash -8T(c)(5) Funds deposited into borrower s account -8T(c)(4)t-  ( -  ( 'Debt proceeds not disbursed to borrower((&-8T(c)(3) Categorize by treating as if borrower did receive funds and used them EX  buy rental property and assume the debt on it. Assuming is a passive activity, have passive activity debt and interest expense Is no 15-day rule (or 30-day rule) applicable6P.P.!Debt proceeds distributed in cashb-8T(c)(5)  generally, trace to use, otherwise, interest is assumed to be personal 15-day  pretend rule  B may treat any cash expenditure made within 15 days of receiving the cash as made from the debt proceeds Notice 89-35 modifies the 15-day rule to a 30-day before or after rule EX  B borrows $30,000 in cash on 5/1/08 and uses it to pay personal bills on 5/1. B should look to any other cash expenditure made between 4/1/08 and 5/31/08 that would produce deductible interest and  pretend that the cash was really used for that expenditure. Document it!BPGPPG"LDebt deposited into borrower s account''&-8T(c)(4) Deposit into account = investment expenditure Reallocate when debt proceeds used for another expenditure What if the account also has non-borrowed funds  which is presumed used first? -8T(c)(4)(ii)  debt proceeds treated as used before unborrowed funds and before any amounts deposited after the debt proceeds are deposited. 2 exceptions to general ordering rule: (1)  if account only has loan proceeds and interest income from the debt  may treat expenditures as from the interest income -8T(c)(4)(iii)(C) (2) 15 day rule which is modified to 30 day before and after rule by N89-35^sPPPPPsP  #*Example from -8T(c)(4) modified for N89-35++&%Additional rules for debt proceeds deposited into borrower s accountEE&V-8T(c)(4)(iii)  multiple checks written on same day  treat as written in any order -8T(c)(3)(iii)  expenditure from checking account is treated as made when check written, provided check is delivered or mailed to payee within a reasonable period after writing the check What is a reasonable time?&&^More rules for funds deposited into B s account00&-8T(c)(4)(iv)  optional method for determining date of reallocation B may treat all expenditure made during any month from debt proceeds as occurring on later of: 1st day of the month, or Date on which debt proceeds deposited in the account Benefit  may calculate interest for the entire month, rather than treat change in use of debt proceeds as occurring during the month -8T(c)(4)(v)  simultaneous deposits  if 2 or more debt deposited into account at same time, treat as deposited in order debts were incurred. If truly simultaneously created, then B may chose which was incurred first. Debt on which interest accrues at different rates are treated as separate debt. For example, line of credit with fluctuating interest rate. If draw on credit on Feb 1 at 7% rate and draw again on April 1 at 7/5% rate, have 2 different debts.EP_PNPPPE_ K  (QuestionTZena borrowed $40,000 and used it as follows (it was deposited into her checking account): $10,000 to pay off credit cards $10,000 to pay tuition for 7th grade daughter $20,000 to invest in Garden Villa Apts Ltd Partnership What type of the interest expense does Zena have and what information to you need from her to answer this question?R[t[< Ht*=Debt proceeds used to pay borrowing costs or interest expense>>&"-8T(c)(6)(ii) & (iii) If debt proceeds used to pay interest on another debt  categorize the interest on 2nd debt same as on 1st debt If debt proceeds used to pay borrowing costs of a different debt  categorize interest same as on other debt. If debt proceeds used to pay borrowing costs of that same debt (borrowing costs were added to the debt balance)  categorize same as for balance of the debt.BZj  +Debt repayment-8T(d) If debt repaid was a multi-use debt, and only part of the principal was repaid, then apply following ordering rule to determine which  use of debt was repaid: Amounts allocated to personal expenditures Investment expenditures and passive activity (other than RRE-AP)  within this class, treat repayment as going towards whichever expenditure was made first. If made on same day, then taxpayer choice. RRE-AP Former passive activity expenditure Trade or business4Z0qZ0,Debt refinancings1-8T(e) If refinanced debt is only used to pay off part of the original debt, then apply the repayment ordering rules to determine character of interest expense, assuming original debt was a multi-use debt. If refinanced debt > original debt, categorize interest on excess debt under general tracing rules.0Reallocation of debt-8T(j) General rule: debt allocated to an expenditure chargeable to a capital account must be reallocated to another expenditure at earlier of: Date original asset is sold and proceeds are used for something else Date on which use of the asset changes, such as from business to personal&2QuestionLIn 2007, B borrowed $20,000 from her bank and used the proceeds to pay off $14000 of personal debts, $3,000 to buy a new computer for her Sch C business and the balance to invest in a ltd partnership which is a passive activity to her. In 2009, B makes first payment of principal, paying $15,000. What part of the debt has she paid?3Debt & Passthrough Entities-8T(f)  (i)   reserved IRS provided the rules in Notices N89-35 provides rules on how to categorize interest expense when: A) owner borrows to acquire interest in p/s or S corp B) p/s or S corp borrows and distributes debt proceeds to owners&~w~w6CDebt related to acq of interest in passthru entity per Notice 89-35DD&8QuestionWilliam is a shareholder in an S corp and is also an employee of the corporation. William borrowed $50K to acquire stock in the corp. Is the interest expense trade or business or investment interest expense?9LQuestion  p/s borrows and distributes''&Partnership PQ s property has greatly appreciated in value and there is no debt on it. General partner thinks it would be wise to borrow $500K against the property at 5% rate in order to make a distribution to the partners. PQ s normal operating expenses are about $110K per year. Explain to general partner how the interest expense is to be reported on partners K-1s and what he should tell the partners about categorizing their interest expense.; *Policy  why tracing?Could IRS have used an approach other than tracing for the -8T regs? Preamble to -8T regs notes that some taxpayers may attempt to manipulate the tracing rules and future regs might contain some anti-abuse or special rules Other approaches IRS could have considered: Pro rate allocation Problem  what base to use? If need to allocate based on FMV of borrower s assets, would require appraisals How debt is secured  Carrying an asset  similar to old prop reg at 1.57-2(b)(1)(iii)  similar to the interest capitalization rules where expenditures exceed traced debt  avoided cost methodvEZZZmZZEm<!"How are late fees on debt treated?|Was the fee paid for the use or forbearance of money? Yes  likely is interest No  see if is a T or B expense under 162 fyi Rev Rul 69-189, 71-98, 72-315, 73-136 Bailey, TC Memo 1991-385, aff d (11th Cir,1992)  struggling business incurred regular overdraft charges/fees; held not ordinary and necessary under 162j6ZDZZZ6DIuC"Borrowing from same lenderLQuery  has the borrower really paid anything? Arguably still in same position  owes $ to original lender Battlestein (5th Cir. 1980) Wilkerson (9t Cir. 1981) Also noted in IRS Pub 535 Exception where account where 2nd loan proceeds were deposited also had other funds: Burgess, 8 TC 47 (1947)/<OU/<?4 E#Personal interest expenseNon-deductible starting with TRA 86 Rationale: BB pg 263 Deductibility created incentive to borrow Also, because supported incentive to invest in consumer items rather than investments EX  tax law doesn t require reporting of imputed rental value of owner-occupied housing But kept home mortgage int deduction because of  important policy goal of home ownership Examples? Try to avoid via HEI (although are putting home at risk) and 30-day rule of the tracing rulesv9ZZYZZZhZ9YZ  hM*!221 Interest on education loans Added by TRA 97 Rationale:  many students incur considerable debt in the course of obtaining undergraduate and graduate education. The Committee believes that permitting a deduction for interest on certain student loans will help to ease the financial burden that such obligations represent. Several limitations: Overall: $2,500 Modified AGI limits Limits based on definition of  qualified education loan and  qualified higher education expenses No deduction if taken under some other provision@**F$Investment interest limitation2163(d) and Form 4952 Deduction cannot exceed  net investment income NII = excess of investment income over investment expenses  Investment income =  the sum of (i) gross income from property held for investment (other than any gain taken into account under clause (ii)(I)), (ii) the excess (if any) of (I) the net gain attributable to the disposition of property held for investment, over (II) the net capital gain determined by only taking into account gains and losses from dispositions of property held for investment, plus (iii) so much of the net capital gain referred to in clause (ii)(II) (or, if lesser, the net gain referred to in clause (ii)(I)) as the taxpayer elects to take into account under this clause. Such term shall include qualified dividend income (as defined in section 1(h)(11)(B)) only to the extent the taxpayer elects to treat such income as investment income for purposes of this subsection. Amount not deductible in current year carries forward indefinitely subject to same limitation in subsequent yearsFPPPPrPFv`r    0 0Sc 0 0 3 0I%.Investment interest expense limitation example//&Mr. and Mrs. Smith have following for 2007. They prefer to have any income tax can be taxed at a lower rate treated that way. Sch B interest income $23,000 Qualified dividends $1,000 Int exp to acquire int in ltd partnership X (80% of assets are rental and 20% are portfolio) $3,000 Margin account interest $37,000 AGI $133,000 Investment expenses $2,500 Other misc itemized deductions $3,300PJ&AnswerInvestment income $23,000 Less: Inv expenses ( 2,500) NII $20,500 Inv int expense: Margin loan $37,000 P/S 600 ($3,000 x 20%) total $37,600 Excess to carryforward to 2008 $17,100 L^w. $E*K'Tax-exempt interest expense^265 1.163-8T(m)(2)(i)  generally,  any limitation on the deductibility of an item (other than the passive loss and nonbusiness interest limitations) applies without regard to the manner in which debt is allocated under this section. Thus, for example, interest expense treated under section 265(a)(2) as interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from Federal income tax is not deductible regardless of the expenditure to which the underlying debt is allocated under this section. 0Z0N(OHow to determine if interest expense is properly allocable to tax-exempt incomePP&Reg. 1.265-1(c)   Allocation of expenses to a class or classes of exempt income. Expenses and amounts otherwise allowable which are directly allocable to any class or classes of exempt income shall be allocated thereto; and expenses and amounts directly allocable to any class or classes of nonexempt income shall be allocated thereto. If an expense or amount otherwise allowable is indirectly allocable to both a class of nonexempt income and a class of exempt income, a reasonable proportion thereof determined in the light of all the facts and circumstances in each case shall be allocated to each. 1.163-1(d)  statement required to be included on tax return 1.163-10T(b)  QRI rules subject to 265(a). EX  borrow home equity loan and use of proceeds to purchase tax-exempt bonds then of interest expense is not deductibleDP}P>u}O)ReviewImportant to know type of interest expense an individual has Generally  apply tracing rules of 1.163-8T and Notices If secured by PR or second home  ck if QRI in which case tracing n/a Unless elect under 1.163-10T(o)(5) to treat as NOT secured by residence Planning possibilities Recordkeeping important to prove type of interest expense you have at all timesV=Z~ZHZgZ=~Hg/ ! $ ' ) -./1457:=>?@ABDGHLP Q!R"}  0  $(   r  S  `}   r  S  `  H  0޽h ? ___f3̙;/f9___PPT10i.+D=' = @B +rnk0s n2R