Interest Tracing Rules Overview
In this section, you will find a complete overview of interest tracing, an often overlooked aspect of the Internal Revenue Code in the United States.
Overview
How to treat interest expense for tax purposes is sometimes complicated. The simple answer is that it depends on the character of the interest. That is, we know personal interest is not deductible while business interest is.
The character of the interest depends on the character of the loan and the character of the loan depends on what the loan proceeds were spent on. In other words, the use of the loan funds must be “traced.” If the loan was used for personal purposes, like funding a cruise, the character of the loan is personal and may not be deducted (IRC Sec 163(h)(1)). If the funds were used for purchase of a business car (assume 100% business use) or for funding working capital in a business, the interest is business and is deductible (IRC Sections 163(a) & 162).
In the same way, if a taxpayer borrows money secured by rental #1 and uses the loan proceeds to purchase rental #2, then the character of the interest would be related to and deductible on the Schedule E of rental #2. If loan proceeds are used to buy stocks and bonds, then the interest paid is allocable to purchase of the securities and therefore becomes investment interest.
Related IRS Publications and Other References
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Reg. Sec. 1.163-8T (the IRS has never issued final regs)
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See Guide – Higher Education Interest
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See Guide – Home Mortgage Interest
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See Guide – Investment Interest
One of the more misunderstood and often overlooked tax issues is this concept of interest tracing. The income tax regulations refer to it as “allocation” of debt and interest. Though the concept is straightforward, it can get complicated.
The tracing rules are generally summed up as follows:
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. (Reg Section 1.163-8T(a)(3))
Interest expenses generally fall into commonly understood categories, and the treatment of the interest for tax purposes depends upon which category it falls into:
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Personal Interest – Not deductible says Section 163(h)(1);
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Trade or Business Interest - Generally deductible under Section 163(a) and Section 162;
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Investment Interest – Generally deductible under Section 163(a) and Section 212(1) and/or (2), but the amount of deductible investment interest is limited by Section 163(d) to net investment income
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Interest Related to a Passive Activity, which is considered under Section 469 in computing income or loss from a passive activity.
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Qualified Residence Interest within the meaning of Section 163(h)(3);
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Educational Loans – Any interest paid on educational loans and allowable as a deduction under Section 221. (Note that educational loans are personal and would not be deductible because of Section 163(h)(1) were it not for Section 221.)