Loan proceeds and passive activity losses.

Editor's note: this case study has been adapted from "PPC Tax Planning Guide--Partnerships," 11th edition, by Grover A. Cleveland, William D. Klein, Terry W. Lovelace, Sara S. McMurrian, Linda A. Markwood and Richard d. Thorsen, published by Practitioners Publishing Company, Fort Worth, Tex., 1997.

Facts: Janis is a 60% partner in the JAX Partnership and materially participates in its operations. TAX is going to make two substantial purchases: (1) a large machine for use in the business (costing $ 100,000) and (2) land for investment, (also, costing $100,000). The partnership has the funds to pay cash for either the machine or the land (but not both), and will have to borrow the money for one of the purchases. Interest expense on the loan will be approximately $12,000 for each tax year. On her personal return, Janis shows interest income of $1,000 and a $75,000 guaranteed payment received for the use of capital. JAX pays no other interest and has ordinary income of approximately $50,000 per year (after deducting the guaranteed payment to Janis). JAX's tax adviser realizes that certain interest expense paid by a partnership must pass through to the partners as investment interest. Issues: Can the borrowed funds be used so that the passthrough of investment interest expense is minimized or eliminated? Is it preferable to use the borrowed funds to purchase the land or to purchase the machine, or does it make a difference?

Analysis

There are six different classifications of interest expense, and each requires different treatment on a partnership tax return:

1. Trade or business interest expense reduces the partnership's nonseparately stated ordinary income on page 1 of Form 1065, U.S. Partnership Return of Income.

2. Investment interest expense passes through as a separately stated item and is subject to limitation at the partner level.

3. Real estate rental interest expense reduces passive activity income from rental real estate.

4. Real estate rental interest expense from an activity in which the taxpayer is an "active" participant reduces passive activity income from rental real estate.

5. Other (non-real estate) rental interest expense reduces passive activity income from other rentals.

6. Partner interest expense passes through as a separately stated item to partners, who then determine the nature of the expense at the partner level.

The general rule is that the character of interest expense is determined by reference to the use of the debt proceeds (the interest tracing method). For example, if debt proceeds are used to buy inventory, the interest expense on that loan is a business expense (active or passive, depending on participation). However, if debt proceeds are used to acquire rental property, the interest expense on that loan is a rental expense (passive). If the loan proceeds are used for more than one purpose (such as to purchase inventory and rental property), the interest expense must be allocated between the activities.

The type of property pledged to secure a loan does not affect the nature of the interest expense (except for an individual's qualified home equity debt). For example, if investment property is pledged as collateral, but loan proceeds are used to purchase inventory, the interest expense is a business expense rather than investment interest expense--the nature of the property securing the debt is irrelevant.

Under the interest tracing method, taxpayers can manipulate the tax treatment of the interest expense by determining the best way to use the loan proceeds. In the preamble to the temporary regulations that established the interest tracing method, the IRS acknowledges this potential problem and reserves the right to issue additional regulations to prevent abuse.

Temp. Regs. Sec. 1.163-8T(c)(4) provides special rules for the allocation of interest expense when loan proceeds are commingled with other funds. One of these rules states that amounts expended within 15 days after loan proceeds are deposited can be treated as if the amounts expended came from those loan proceeds. For example, assume JAX Partnership borrows $100,000 and deposits the proceeds in its checking account on August 1. On August 12, the partnership buys the machine for $100,000 and on the same day buys the land for $ 100,000. Both purchases were made with checks from the same checking account. Temp. Regs. Sec. 1.163-8T(c)(4)(iii) permits the loan proceeds of $100,000 to be treated as used to purchase either the machine or the land. The easiest and cleanest way to deal with the rules, however, may be to avoid commingling loan funds. Assuming transactional costs are minimal, each loan could be placed in a separate account with only appropriate expenditures being made from that account. This would virtually eliminate arguments as to the use of the funds.

Using the tracing method, if JAX borrowed the funds to buy the machine, the interest expense would be treated as incurred in the operation of the business and would reduce the nonpassive (ordinary) income passed through to Janis. The interest expense would be investment interest expense if the borrowed funds were used to purchase the land. Investment interest expense is deductible only to the extent of investment income. The nondeductible portion carries forward to be used in a year when there is sufficient investment income.

The results on Janis's personal return are as follows:

If the proceeds are used to buy the machine:

Guaranteed payment                   $ 75,000
Interest income
 (portfolio income)                     1,000

Passthrough from JAX:
 Ordinary income
  [($50,000 - $12,000
  interest expense
  = $38,000) X 60%]                    22,800

Adjusted gross income                $ 98,800

If the proceeds are used to buy land held
for investment:

Guaranteed payment                   $ 75,000
Interest income
  (portfolio income)                    1,000
Passthrough from JAX:
  Ordinary income
  ($50,000 X 60%)                      30,000
Investment interest
  expense

Adjusted gross income               $ 105,000(*)

(*) The $7,200 ($12,000 X 60%) of investment interest expense is deductible by Janis as an itemized deduction, but only to the extent of her investment income (in this case,$ 1,000).

Conclusion

The tax treatment of interest expense incurred by a partnership is determined by reference to how the funds are used (the interest tracing method). This permits taxpayers to specify (within certain limits) the purpose for which loan proceeds were expended and thereby control the characterization of the related interest expense. It may, however, be appropriate to deposit borrowed funds in separate accounts and make only specific types of expenditures from those accounts, to minimize recordkeeping headaches and maximize the deductibility of interest expense. In this situation, the best tax results for Janis are achieved if the borrowed funds are used to buy the machine instead of the land.