Carryover of pre- 1987 investment interest expense.

• Author: Klaus, Kenton J.

In tax years beginning before 1987, noncorporate taxpayers were entitled to deduct investment interest expenses to the extent of net investment income plus $10,000. Investment interest expense deductions above that amount were disallowed under Sec. 163(d)(1), but an indefinite carryover of the disallowed amount to succeeding years was permitted under Sec. 163(d)(2). Before the Tax Reform Act of 1986 (TRA), Sec. 163(d)(3)(E) provided that "disallowed investment interest" meant the amount not allowable as a deduction solely because of the limitation in Sec. 163(d)(1). Because the term "solely" was removed from the language of Sec. 163(d) in 1986, the following discussion does not affect investment interest expenses incurred in tax years beginning after 1986.

In Beyer, 92 TC 1304 (1989), rev'd, 916 F2d 153 (4th Cir. 1990), nonacq., the IRS asserted that Congress did not intend to allow taxpayers an investment interest expense carryover in excess of their taxable income. Thus, non-corporate taxpayers who complied with the Service's taxable income limitation on investment interest deductions and carryovers on any pre-1987 returns should take note of the reversal of the Tax Court's decision in Beyer. For any open tax years still under the statute of limitations, refund claims should be considered.

At issue in Beyer was whether interest expense that was "clearly not allowable" under Sec. 163(d)(1), "was |otherwise allowable' because [Sec.] 163(d)(1) was the |sole' basis for excluding the deduction." The Fourth Circuit held that the carryover of disallowed investment interest expense generated in the current year was not limited to taxable income for that year. However, the court did not disturb the Tax Court's holding that the carryover of excess investment interest from earlier years was not limited by the current year's taxable income. Thus, the full amount of investment interest disallowed by the Sec. 163(d)(1) limitation was carried over to future years indefinitely.

IRS position

The Service argued that an inherent limitation in the tax system prevented taxpayers from claiming deductions in excess of their taxable income for a given year, i.e., taxable income cannot be a negative amount. Following this reasoning, the IRS argued that any investment interest expense disallowed under Sec. 163(d)(1) that exceeded current year taxable income could not increase a net operating loss (NOL) under Sec. 172. (Ordinarily, excess investment interest...