Interest deduction on debt-financed distributions.

• Author: Lee, K. Joseph

Although the real estate market has cooled off in many areas, the value of commercial properties seems to have been less affected than that of residential properties. In fact, many commercial properties continue to be worth substantially more than their historic cost. Most commercial and investment properties are owned by partnerships, limited liability companies (LLCs), or S corporations. The owners are often tempted to cash out on the appreciation and equity of the properties through refinancing and assume that the mortgage interest is deductible by the passthrough entity. This is not always the case; deductibility depends on how proceeds are used at the owner level.

Example: Partnership P owns a shopping mall rented to various commercial tenants. It has a $2 million existing mortgage and its operation breaks even with $1 million annual rental income and expenses. P would like to refinance a new mortgage for $10 million. After paying off the existing mortgage of $2 million, P distributes the remaining $8 million to the partners.

P cannot deduct interest associated with the $8 million distribution. Instead, the interest expense is separately disclosed on each partner's Schedule K-l, Partner's Share of Income, Deductions, Credits, etc., and deductibility depends on how each partner uses the proceeds.

Generally, under Temp. Regs. Sec. 1.163-8T(a)(4), if the proceeds are used for items of a personal nature (e.g., a sports car, vacation, or home upgrade), the related interest expense is not deductible. Conversely, if the proceeds are used in income-producing activities or investments, the related interest expense would be deductible. In addition, the deduction for interest expense is limited to net investment income; the excess investment interest expense can be carried forward to future years. Net investment income generally includes interest, dividend, annuities, and royalties; it does not include qualified dividends and net capital gain. However, a taxpayer can elect to include qualified dividends and net capital gain as investment income. The election can be made by completing a specific line on Form 4952, Investment Interest Expense Deduction. If the taxpayer chooses such treatment, qualified dividend income and net capital gain are not eligible for lower capital gains tax at 15%, but the net investment income can be offset by investment interest expense.

Many practitioners confuse investment expense with investment interest expense...