If children can learn to trace, why is it so difficult?

The longer you live, the more things can make you think, “That 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 interests cannot be deducted, unless they are incurred for a residence. Investment interest can offset investment income. Business interest can be deducted in full, although more recent reforms limit the deduction for very large taxpayers.

What Congress left out was how you classify your interest expense. The Treasury had to fill in the gaps, which it did by regulation. These regulations were drafted in July 1987 and revised in July 1997.

In 1987, the new regulations promulgated aroused great interest. Tax professionals attended seminars to learn the rules. Newspaper articles have probed the details of the many examples found in the regulations.

The regulation said to “trace” the use of the proceeds of the loan to classify the resulting interest. If the borrowed money is used to purchase an investment, the interest is classified as an investment, and so on.

When a lender disburses funds directly to the seller of a property, as happens in real estate foreclosures, tracing isn’t too difficult.

What spoils things 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, what funds are linked to the expenditure?

Where a partnership is the borrower and distributions are then made to the partners, are those distributions from loan proceeds or from other funds the partnership may have?

If the distributions were from loan proceeds, the partnership cannot “trace” the interest. The partner must now do the tracing. Yet the partnership pays the interest and must file it.

Sound familiar? I did not think. It’s a problem. The tax treatment of interest after 1986 must use these traceability rules. If they are unfamiliar to borrowers, or even their tax advisors, what exactly appears on these tax returns?

Tracing can be easy in two situations. First, the lender transfers the funds directly to the intended use, such as buying real estate. Second, the borrower has assumed the existing debt on the property he is acquiring.

Where loan proceeds are received in cash or deposited into an account, any use of funds within 15 days can be attributed to the loan. This is so even if the account has unborrowed funds in addition to borrowed funds.

Refinanced debt is charged to the same use as the debt it replaces, but only up to the principal balance at the date of refinancing. Excess refinancing proceeds are tracked like any new debt.

The same loan can be attributed to several uses. As the debt is repaid, an order rule must be applied to determine which category of debt has been repaid.

The regulations are taxpayer-friendly and reduce categories of debt in an order that first targets non-deductible personal interests while preserving deductible business interests for the last step.

Perhaps the trickiest trace concerns a partnership debt. Partnerships are said to be “passing through” entities because they simply tell each partner what their share of each declared item is.

Items that are treated the same for all partners are reported in a single “ordinary income or loss” category. All elements that could be treated differently depending on the situation of each partner must be declared separately.

Let’s say a partnership borrows $1 million. If the partnership retains or uses all funds, the partnership tracks the uses and reports the interest classification to the partners.

If the partnership distributes any portion of the loan proceeds, it cannot trace the use of the distributed funds.

If $300,000 of the $1 million debt proceeds are distributed to the partners, the partnership must report 30% of its interest separately to the partners. The partnership simply calls this debt financed distribution interest.

Each partner must then determine what has been done with the distribution. Tracing at partner level then determines the tax result.

Does your chewing gum lose its flavor on the bed overnight? Thirty-five-year-old regulations can be ignored for the same reason.

Jim Hamill is the Tax Practice Manager at Reynolds, Hix & Co. in Albuquerque. He can be reached at [email protected]

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