Interest Expense Limitations
for Individuals
Topics
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What 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:
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Personal interest
Interest on education loans (IRC §221)
Investment interest + interest related to tax-exempt
activities
Home mortgage interest
Interest expense – pre-classification issues
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Possible tax issues:
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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?
What is debt?

Naguchi, 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.“”
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).”
AWG - continued
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“The Sixth Circuit has embraced the Second
Circuit's definition of “debt” for tax purposes as:
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[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).”
Who can potentially deduct interest
expense?
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Assuming it falls into a deductible category …
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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.”
Clarification of §1.163-1(b)
Golder, Jr., 604 F.2d 34 (9th Cir. 1979)
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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:
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"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. 1.1631(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.”
Overview to individual interest limitations
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Why needed:
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§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
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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’86
Authority to issue interest tracing regs
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§469(l)(4) – “Regulations. The Secretary shall
prescribe such regulations as may be
necessary or appropriate to carry out
provisions of this section, including
regulations—
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(4) which provide for the determination of the
allocation of interest expense for purposes of this
section”
General authority under §7805
Interest tracing basics
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Reg. §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.”
What is included in interest expense?
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1.163-8T(c)(2)(ii)(C):
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Relevant provisions of the loan agreement
OID rules
Unstated interest per §§483, 1271 - 1275
Examples – categorize the following
1.
2.
3.
4.
5.
6.
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.
Mechanics of Interest Tracing Rules
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Somewhat complex and detailed.
Special rules provided for:
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How the money was rec’d (in cash, in an account, sellerfinancing (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)
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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.
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Does not matter if taxpayer pays interest late when the
debt has been reallocated to a different use
Ways of borrowing money
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Lender keeps the proceeds (seller financing)
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Borrower received in cash
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-8T(c)(3)
-8T(c)(5)
Funds deposited into borrower’s account
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-8T(c)(4)
Debt proceeds not disbursed to borrower
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-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.
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Assuming is a passive activity, have passive
activity debt and interest expense
Is no 15-day rule (or 30-day rule) applicable
Debt proceeds distributed in cash
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-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
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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!
Debt deposited into borrower’s account
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-8T(c)(4)
Deposit into account = investment expenditure
Reallocate when debt proceeds used for another
expenditure
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What if the account also has non-borrowed funds – which
is presumed used first?
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-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:
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(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
Example from -8T(c)(4) modified for
N89-35
Date
Deposits
1/10
Debt A
1/10
Gift
1/11
Debt B
Withdrawals
$500
$1,000
$500
2/17
$800 personal
2/26
$700 PA
6/21
Debt C
$1,000
11/24
$800 Inv exp
12/20
$600 personal
Additional rules for debt proceeds
deposited into borrower’s account
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-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
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What is a reasonable time?
More rules for funds deposited into B’s
account
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-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:
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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.
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1st day of the month, or
Date on which debt proceeds deposited in the account
Question
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Zena borrowed $40,000 and used it as follows (it
was deposited into her checking account):
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$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?
Debt proceeds used to pay borrowing
costs or interest expense
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-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.
Debt repayment
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-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:
1.
2.
3.
4.
5.
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 business
Debt refinancings
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-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.
Reallocation of debt
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-8T(j)
General rule: debt allocated to an
expenditure chargeable to a capital account
must be reallocated to another expenditure at
earlier of:
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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
Question
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In 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?
Debt & Passthrough Entities
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-8T(f) – (i) – “reserved”
IRS provided the rules in Notices
N89-35 provides rules on how to categorize
interest expense when:
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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
Debt related to acq of interest in passthru
entity per Notice 89-35
“Contributions”
“Purchases of Interests”
Example:
Borrow from bank and
contribute proceeds to p/s
or S corp to acquire an
interest
Borrow from p/s or S to
acquire the interest
Interest allocation
method per N89-35
Any reasonable method
Allocate among entity
assets using any
reasonable method
Examples of
Allocate among entity’s
reasonable methods 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 activity
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
already
Question
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William 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?
Question – p/s borrows and distributes
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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?
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Could IRS have used an approach other than
tracing for the -8T regs?
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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:
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Pro rate allocation
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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 method
How are late fees on debt treated?
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Was the fee paid for the use or forbearance
of money?
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Yes – likely is interest
No – see if is a T or B expense under §162
fyi
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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 §162
Borrowing from same lender
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Query – has the borrower really paid
anything?
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Arguably still in same position – owes $ to original
lender
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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)
Personal interest expense
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Non-deductible starting with TRA’86
Rationale: BB pg 263
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Deductibility created incentive to borrow
Also, because supported incentive to invest in consumer
items rather than investments
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EX – tax law doesn’t require reporting of imputed rental value
of owner-occupied housing
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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 rules
§221 Interest on education loans
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Added by TRA’97
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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:
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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
Investment interest limitation
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§163(d) and Form 4952
Deduction cannot exceed “net investment income”
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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—
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(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 years
Investment interest expense limitation
example
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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 $3,300
Answer
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

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Investment income
Less: Inv expenses
NII
Inv int expense:
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$23,000
( 2,500)
$20,500
Margin loan $37,000
P/S
600 ($3,000 x 20%)
total
$37,600
Excess to carryforward to 2008
$17,100
Tax-exempt interest expense
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§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.”
How to determine if interest expense is
properly allocable to tax-exempt income


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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 ½ of proceeds to
purchase tax-exempt bonds then ½ of interest expense is not
deductible
Review

Important to know type of interest expense an
individual has
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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


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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 times