Deduction canceled for lack of interest - tax reform

Nation's Business,  Oct, 1987  by Gerald W. Padwe

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Deduction Canceled For Lack Of Interest

Yet another complexity added by the 1986 tax-reform act's "simplification' is its treatment of individual-interest expense.

Before 1987, the rules were relatively straightforward. If interest was paid to purchase tax-exempt bonds, it was not deductible. If it was paid to purchase or carry other investments, it was shown on Form 4952 and was deductible up to the amount of net investment income plus $10,000. Other interest was deductible on Schedule A or Schedule C.

Starting this year, deductibility gets tougher. Municipal-bond-interest and business-interest rules stay the same. The $10,000 shelter provided for investment-interest deductions will be phased out over five years, and the definitions of both investment interest and net investment income also are changed.

A new interest "basket' is created for "passive activities' (yes, that really is the term), including limited-partnership units and a good deal of real-estate rental. Net expenses (including interest) from these activities will be deductible only against income from other passive activities. Interest on loans secured by a first or second home is deductible.

And, finally, other personal interest becomes nondeductible over a five-year period. (Only 65 percent will be allowed in 1987.)

With tax deductibility or nondeductibility varying according to the type of interest expense, the characterization of interest payments has become critical. Recently, the Internal Revenue Service issued a set of proposed and temporary regulations to guide individual taxpayers as they structure financial transactions in 1987.

Two general approaches to characterizing interest were available to the IRS and the Treasury Department: tracing the proceeds of the loans or apportioning interest expense based on the taxpayer's overall financial posture. The proposed regulations take the first approach. The regulations aren't final yet, so both methods are worth a look.

Apportioning interest expense

The apportionment approach recognizes that a specific loan decision today may really be only part of an overall financial strategy with longer-term effects. So the purpose for which today's loan is taken out is less important than overall financial posture.

Assume your assets include a home valued at $400,000; stock portfolio of $200,000; municipal bonds of $50,000; passive activities of $150,000; and personal assets of $200,000 for a total of $1 million.

One approach to apportionment would conclude that mortgage interest is treated separately, but any other amount borrowed is to assist the taxpayer's total financial picture. Therefore, regardless of the purpose for the immediate loan (say, to pay a college tuition bill), interest would be allocated pro rata based on the relative values of the non-home assets--$600,000 in this example.

Thus, 50/600 would be apportioned to the municipal-bond portfolio, and therefore nondeductible. Another 150/600, or 1/4, would be treated as a passive-activity expense, and so on.

There are drawbacks to this approach. It apparently would require all borrowing individuals to have accurate valuations of assets performed periodically --an expensive and certainly controversial requirement.

An alternative to using fair-market value would be to apportion based upon the relative tax costs of all assets held by a borrowing taxpayer. If that were the rule, though, how successful would you be in providing an examining agent with documentary evidence as to the tax cost of your household furniture and effects? How much work would you have to do to determine the present tax cost of limited partnerships you have been in for several years?

Tracing the proceeds

Because of the difficulties inherent in an apportionment approach, the regulations call instead for tracing interest costs based on use of the loan proceeds. Though such a rule brings its own set of problems, it should be substantially more practical than one based on apportionment.

It also requires you to have a thorough understanding of how the IRS will view loan transactions reported on your return.

Suppose, for example, you were to borrow $25,000 from your family business, and interest payments are made directly to your closely held corporation (of which you are an officer, and where you spend your full working day). With the $25,000, you buy a new car for nonbusiness use. Although the interest payments are to your business, the proceeds were for personal use and the interest is personal interest. If, instead, the $25,000 was used for increasing your stock portfolio, the interest would be investment interest. If $15,000 were spent for the car and $10,000 for stocks, 60 percent of the interest would be personal and 40 percent investment.

Often, however, a taxpayer will borrow funds, deposit them in his checking account and commingle them with whatever other money is in the account. In this common situation, the rules are somewhat mechanical. Any payment from that account within 15 days of depositing the loan proceeds may be treated as coming from those proceeds. Any expenditures after the expiration of 15 days must be treated as coming from the debt proceeds, up to the amount of the loan.