Real Estate Partnership Debt Financed Distributions and the Effects of Interest TracingBy Steve Brodsky | February 19, 2020
A recent Tax Court decision favorable to the taxpayer puts a spotlight on the appropriate treatment of partnership interest expense from a debt finance distribution and the significance of the interest tracing rules. Lipnick v. Tax Commissioner ruled that, in the context of a transfer of a partnership interest, the transferee is not bound by the transferor’s tax treatment of its allocable share of interest expense.
The facts and circumstances of the case are quite simple and common in the real estate industry. A father owned interests in several real estate partnerships in which he materially participated. The partnerships refinanced their property and distributed out some of the funds received to its partners in what is typically referred to as a debt-financed distribution. The debt was nonrecourse to the partners and was secured by the partnerships’ real estate assets. The father used the cash he received from the partnerships to make investments in items such as money market funds and other investment-type assets. The partnerships incurred interest expense on the debts, and the father properly deducted his distributive share of the interest expense as investment interest expense on his 1040, Schedule A.
Shortly thereafter, the father transferred a portion of his partnership interests to his son through gifts, and the remaining partnership interests were ultimately transferred to his son upon the father’s death. The son, like his father, also materially participated in the operation and management of the real estate partnerships. For all subsequent years, the son treated his allocable share of the partnership interest expense as related to the indebtedness allocable to the partnership's real estate assets and consequently deducted the interest expense on his 1040, Schedule E, as an offset to his share of the partnership income from real estate operations. Upon audit, the IRS claimed the son should have reported the interest expense as investment interest on his Schedule A, consistent with the way his father had previously reported it. Since the son did not have enough investment income against which to deduct the interest expense, the IRS disallowed the deduction reported on Schedule E.
Generally, Temporary Regulations issued in 1987 under Section 163 provide a tracing rule for determining when debt is properly allocable to property held for investment. Additionally, these same Temporary Regulations state that debt is allocated to expenditures in accordance with the use of the debt proceeds. In other words, debt is allocated by “tracing” disbursements of the debt proceeds to specific expenditures or uses. For example, if a taxpayer uses debt proceeds to make a personal expenditure, such as taking a vacation, the interest expense is treated as a nondeductible personal interest. If a taxpayer uses debt proceeds in connection with a passive activity, the interest expense is subject to the passive loss limitations. And, if a taxpayer uses debt proceeds to make an investment, the interest incurred on the debt is allocable to such investment and the interest is treated as investment interest expense.
However, the Temporary Regulations do not specify how these tracing rules apply to partnerships and their partners. But the IRS, in published guidance set forth in Notice 89-35, stated that if a partnership makes a debt-financed distribution to a partner, each partner’s use of the proceeds determines whether the interest expense passed through to him constitutes investment interest. So, if a partner uses the proceeds from a debt-financed distribution to acquire property that he holds for investment, the corresponding interest expense incurred by the partnership and passed on to him will be treated as investment interest regardless of whether the debt originated in the partnership.
In the case before the Tax Court, it was undisputed that the father purchased investments with the debt-financed distributions he received from the real estate partnerships, and thus, interest passed through to him was properly treated as investment interest. However, his son never received debt-financed distributions from the real estate partnerships nor did he acquire investments with any of the distributions. So, the question before the Tax Court was simply whether the son was required to treat the interest expense passed through to him by the partnership in the same manner as his father had previously done. In sum, the Tax Court said no, reasoning that the facts that caused the passed-through interest expense to be investment interest expense in the father’s hands did not
apply to his son.
If a taxpayer obtains property subject to debt and no debt proceeds are distributed to the taxpayer, the debt is treated for the interest tracing rules as if the taxpayer used an amount of the debt proceeds equal to the balance of the debt outstanding at such time to purchase such property. In other words, the son is treated as using his allocable share of the partnership debt to acquire his share of the partnership property, i.e., his partnership interest. The son is treated as if he made a debt-financed “acquisition” of his partnership interest, and therefore any interest paid at the partnership level and passed out to him is allocated to the partnership’s real estate assets and his partnership interests. The fact that the son was not personally liable for the partnership debt was of no consequence since those assets were actively managed operating assets and not investment property; therefore the interest expense paid on the partnership debts was not investment interest expense and thus was properly deductible on the son’s 1040, Schedule E.
The interest tracing rules that follow borrowed proceeds are very challenging and whether and how you can deduct the interest is largely based upon how the money you borrowed was spent. Maintaining good records is vital and encouraged, as they can be later referenced to support the use of the proceeds and the ultimate deduction of the corresponding interest expense. Consulting with a tax advisor is always encouraged in such situations.
About Steve Brodsky
Steve D. Brodsky, CPA, JD, LL.M., is a Tax Partner in the Real Estate Group at Marks Paneth LLP. To this role, Mr. Brodsky brings 20 years of accounting experience, with a focus on advising clients on complex tax matters related to the real estate industry. Mr. Brodsky’s areas of specialization include Real Estate Investment Trust (REIT) planning and compliance, tax consulting, and filing of federal and state returns for partnerships/limited liability companies, C and... READ MORE +