Interest one pays is generally deductible for income tax purposes. For real estate owners who borrow against the value of their properties, the interest expense deduction is often one of their largest tax deductions. This tax deduction can be limited. The court in Lipnick v. Commissioner, 153 T.C. 1 highlights how one might avoid this limitation.
Facts & Procedural History
The taxpayer received interests in partnerships from his father. The partnership interests were transferred by way of lifetime gifts from the father and on death by way of an inheritance.
The partnerships invested in an actively managed real estate. This included owing and managing apartment complexes and other real estate.
Prior to the father’s death, the partnerships had borrowed money from third parties. Upon borrowing the money, the partnerships made distributions to the father. The father used the funds to buy CDs and other personal investments.
When the taxpayer-son was transferred the partnership interests, he agreed to be bound by the operating agreements. He did not personally guarantee the loans.
The tax litigation focused on the deductible of the interest expense. During the father’s lifetime, the father reported the interest as “investment interest” on his Schedule A, Itemized Deductions. The son reported the interest as nonpassive “trade or business interest” on his Schedule E, Supplemental Income and Loss, as a reduction to his partnership income. By reporting the interest expense in this manner, the son avoided the investment interest expense limitation.
Limitation on Investment Interest Expense
The limit on interest expense deductions is found in Sec. 163. This sets out the general rule that interest paid is deductible.
But not all interest is deductible. For example, personal interest is not deductible. Personal interest does not include investment, business, or passive interest.
The Code goes on to limit the amount of investment interest expense that is deductible. The deduction is limited to the amount of interest income received.
Unlike a tax attorney, those who own real estate may not appreciate this scheme that grants a tax deduction, takes the tax deduction away but allows others to qualify, only to have the tax deduction limited for some but not all taxpayers.
Is it “Investment Interest” or Something Else?
When a partnership borrows funds and distributes those funds to the partners, one has to look to how the partner used the funds to determine whether the interest is investment, business, or passive.
If the loan proceeds are used to purchase an investment, the interest paid on the loan is deductible as investment interest. If the loan proceeds are used to purchase a business or passive activity, then the interest expense is deductible as a business or passive activity expense.
Interest on Loans Not Tied to Other Assets
That brings us to the issue in this case. What if the partnership interest is acquired by transfer to the new partner? The new partner was not an owner at the time the funds were distributed. As a result, cannot have used the funds to purchase an investment, business or passive activity.
The IRS argued that the new partner, the son in this case, has to continue the same treatment as the prior partner. Thus, if the prior partner used the loan distribution to fund an investment, the interest expense would be investment interest. If a business, business interest. If a passive activity, passive interest.
The court did not agree with the IRS. It concluded that one is to only consider the current partner in classifying interest expense. Because the taxpayer son did not receive a distribution, the taxpayer-son was deemed to have used the loan proceeds to acquire his partnership interests.
Given the facts in this case, the partnership owned and managed real estate that rose to the level of being a business, which is generally true of larger real estate operations where the taxpayer or entity owns and actively manages multiple properties. Thus, according to the court, the loan to acquire this partnership interest was a business interest expense and deductible as business interest expense.
Interest Expense Post TCJA
It should be noted that the business interest expense deduction was not limited to business interest income in the year involved. After the Tax Cuts and Jobs Act (“TCJA”) starting in 2018, business interest expense deduction is subject to a similar limitation as investment interest expense.
But the business interest expense limitation has an important exception that the investment interest expense limitation does not. The business interest expense limitation does not apply to certain smaller taxpayers with less than $25 million in gross receipts. There are exceptions to this small-taxpayer exception that can come into play too.
Assuming these rules can be avoided with advance tax planning, this case stands for the proposition that one can have their partnership borrow funds to pull out their investment in the partnership, make a gratuitous transfer of their partnership to another taxpayer, and the other taxpayer may be able to avoid the limitation on their interest expense deduction.