The longer one lives, the more things can cause you to think, “It seemed like a good idea at the time.”
In 1986, as part of a tax reform movement, Congress eliminated or restricted the deductibility of certain types of interest expense.
Personal interest cannot be deducted, unless incurred for a residence. Investment interest can offset investment income. Business interest can be deducted in full, although reforms that are more recent limit the deduction for very large taxpayers.
What Congress left out was how one classifies their interest expense. Treasury had to fill in the gaps, which they did by regulation. These regulations were drafted in July of 1987 and revised in July of 1997.
Back in 1987, the newly issued regulations were of great interest. Tax practitioners attended seminars to learn the rules. Journal articles probed the details of the many examples found in the regulations.
The regulations said to “trace” the use of loan proceeds to classify the attendant interest. If borrowed money is used to buy an investment, the interest is classified as investment, and so on.
When a lender disburses funds directly to the seller of property, such as occurs in real estate closings, tracing is not too difficult.
What mucks things up is that money is “fungible.” When loan proceeds are deposited into an account, mixed with other funds, and then expenditures are made from that account, which funds are traced to the expenditure?
When a partnership is the borrower and distributions are then made to partners, did those distributions come from the loan proceeds or from some other funds the partnership may have?
If the distributions came from the loan proceeds, the partnership cannot “trace” the interest. The partner must now do the tracing. Yet the partnership pays the interest and must classify it.
Sound familiar? I thought not. That is a problem. The tax treatment of post-1986 interest must use these tracing rules. If they are not familiar to borrowers, or even their tax advisers, what exactly is showing up on those tax returns?
Tracing can be easy in two situations. First, the lender transfers funds directly to the intended use, such as purchase of real estate. Second, the borrower has assumed existing debt on property he or she acquires.
When loan proceeds are received in cash or deposited to an account, any use of the funds within 15 days may be traced to the loan. This is so even if the account has nonborrowed funds in addition to the borrowings.
Refinanced debt is traced to the same use as the debt that it replaces, but only up to the principal balance at the refinance date. Excess refinance proceeds are traced just like any new debt.
A single loan may be traced to multiple uses. As the debt is repaid there must be an ordering rule applied to determine which debt category was repaid.
The regulations are taxpayer-friendly and reduce categories of debt in an order that first targets nondeductible personal interest while preserving deductible business interest for the last step.
Perhaps the trickiest tracing is for a partnership debt. Partnerships are said to be “pass through” entities because they simply tell each partner what his or her share of each reported item is.
Items that are treated the same for all partners are reported in a single “ordinary income or loss” category. Any items that might be treated differently based on each partner’s situation must be separately reported.
Let’s say a partnership borrows $1 million. If the partnership retains or uses all funds then the partnership traces the uses and reports the interest classification to the partners.
If the partnership distributes some of the loan proceeds, the partnership cannot trace the use of the distributed funds.
If $300,000 of the $1 million debt proceeds is distributed to the partners, the partnership has to report 30% of its interest separately to the partners. The partnership simply calls this debt-financed distribution interest.
Each partner then has to determine what was done with the distribution. The tracing at the partner level then determines the tax result.
Does your chewing gum lose its flavor on the bedpost overnight? 35-year-old regulations may be ignored for the same reason.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.
April 04, 2022 at 04:02AM
https://www.abqjournal.com/2485285/if-children-can-learn-to-trace-why-is-it-so-hard-ex-ordering-rules.html
If children can learn to trace, why is it so hard? - Albuquerque Journal
https://news.google.com/search?q=hard&hl=en-US&gl=US&ceid=US:en
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