As most people know, not all interest that an individual pays is deductible. A common misconception about the deductibility of interest expense is that the deductibility follows how the loan is secured. However, this is not true. Just because you pull out a line of credit using your home as collateral does not mean that the interest on the line of credit is residence interest. The rule for deducting interest, in fact, depends on how the loan proceeds are used. This is known as interest tracing.
Interest expense can fall into any of the following categories:
- Investment interest is interest on debt incurred for the purchase of property-held investments, such as stocks and mutual funds, for which the yearly deduction is limited to net investment income. If the investment generates tax-exempt income, the interest is not deductible.
- Residence interest is interest on a home mortgage and is generally deductible as an itemized deduction.
- Passive activity interest is interest on debt incurred for business or income-producing activities in which you don’t materially participate. This is usually deductible only if income from passive activities exceeds expenses from those activities.
- Trade or business interest is interest on debt incurred for activities in which you do materially participate and can generally be deducted in full.
- Personal interest is not deductible.
Example: You borrow $50,000 from a bank and use it to buy a truck to be used in your business (a sole proprietorship). The interest you paid on this debt is treated as a trade or business interest.
It is common for debt proceeds to be placed in an account (checking, savings, and so forth) before being disbursed for its intended purpose. As long as the debt remains in an account of any kind, the debt is considered traced to an investment expenditure, and the interest is treated as investment interest. This rule applies regardless of whether the account is interest-bearing.
The tracing rules become more complex when funds from several different loans are combined in a single account, from which expenditures are made for a variety of purposes. Detailed ordering rules must be applied to match debt with expenditures. For instance, when borrowed funds from several loans are deposited into an account at different times, the funds from the earliest loan are deemed to be used first. However, you can treat any expenditure you make within 30 days before or 30 days after you deposit loan proceeds in an account as being from those proceeds.
KROST Insight: The application of the tracing rule will also be very complicated if borrowed funds are commingled with unborrowed funds. To make your life easier, create a new bank account to hold borrowed funds.
What Happens if the Fund is Subsequently Redeployed?
What happens when the property purchased with borrowed funds is sold or if the use of the property changes? When this happens, the debt must be reallocated. In the case of a sale, the amount of debt that is reallocated cannot exceed the proceeds of the sale. Whereas if the use of the property changes, the debt that is reallocated because of the change cannot exceed the property’s fair market value at the time of the change.
Example: Continuing from the example above, your business no longer needs the truck, and you change the use of the truck to be your own personal vehicle. At the time of change, you still owe $15,000 on that loan, but the fair market value of the truck is only $13,000. Therefore, only $13,000 of the remaining debt is reallocated to personal expenses for which interest is non-deductible.
KROST Insight: The interest on the remaining $2,000 of the loan carries on as trade-or-business interest and is deductible until the loan is paid off.
Example: If instead of converting the truck to personal use and you are able to sell the truck for $18,000, the amount of debt to be reallocated is limited to $15,000. The remaining $3,000 is treated as unborrowed funds, meaning tracing is no longer required.
Repayment of Debts With Multiple Use
When debt proceeds are used for multiple purposes, partial repayments of the debt could create a lot of headaches regarding interest expense allocation. The Regulations provide favorable treatment by allowing taxpayers to apply the repayment first to the most limiting categories in terms of interest expense deduction. This means that the repayment will be applied in the following order to debts allocated to:
- Personal expenditures
- Investment and passive activity expenditures (other than active participation in rental real estate activities)
- Active participation in rental real estate activity expenditures
- Former passive activity expenditures
- Nonpassive trade or business expenditures
If a taxpayer has debt allocated to both investment and passive activity expenditures, the debt is deemed to be repaid on a first-in-first-out basis.
When a debt is refinanced, the new debt is allocated in the same way as the repaid debt. If the amount of the new debt exceeds the amount of the repaid debt, the excess portion is subject to the normal tracing rule.
Example: Using the original example, you decide to borrow $50,000 from a bank and use it to buy a truck to be used in your business (a sole proprietorship). You refinance the debt for a new debt of $30,000 when the balance of the original debt is $13,000. You use the excess of $17,000 to purchase an investment property. As such, interest on $13,000 of the $30,000 is treated as trade-or-business interest, while interest on $17,000 of the $30,000 is treated as investment interest.
The complexity of tax-deductible interest expense requirements and the application of tracing rules can be very tricky. By planning ahead in your loan process and working together with a tax professional, you can utilize tracing rules to unlock tax benefits.
Please contact our team of experts if you have any questions or would like to learn more about the tracing rule.
About the Author
So Sum Lee, CPA, Principal
Tax, Real Estate, Hospitality, Estate & Gift, Trust and Probate
So Sum Lee is a Tax Principal at KROST. So Sum has over 25 years of experience in public accounting and has a wide range of experience in Taxation, as well as servicing high-net-worth clients. So Sum’s area of expertise includes industries such as wholesale, real estate investments, and restaurants. » Full Bio