The Tax Court held that, after a father transferred partnership interests to his son as gifts and bequests, the son properly reported interest expense that passed through to him from the partnerships as allocable to real estate assets held by the partnerships and not as investment interest. The court found no support for the IRS's position that the interest, properly reported by the father as investment interest, retained that character when passed through to the son.
Facts: Maurice Lipnick owned interests in four real estate partnerships. Between 2009 and 2012, the partnerships borrowed money and made debt-financed distributions of the proceeds to the partners. All debt was secured by partnership assets, and neither Maurice nor any other partner was personally liable. Maurice used his share of the distributions to purchase assets he held for investment. Thereafter, the partnerships incurred interest expense on the debts, and Maurice deducted his distributive share as investment interest on Schedule A, Itemized Deductions, of his individual tax returns.
In 2011, Maurice gifted half of his ownership interests in three partnerships to William Lipnick, his son. On his individual tax return for that year, Maurice treated the nonrecourse partnership liabilities of which he was relieved as taxable capital gains. In 2013, Maurice died, and his will bequeathed his interest in a fourth partnership to William, who did not assume personal liability for any of the four partnerships' debts.
On his 2013 and 2014 individual tax returns, William treated his distributive share of interest expense passed through by the partnerships as indebtedness allocable to the partnerships' real estate assets. He therefore deducted it on Schedule E, Supplemental Income and Loss, against his share of the partnerships' real estate income. In 2017, the IRS issued William a notice of deficiency for 2013 and 2014, claiming that he should have reported the partnerships' interest expense as investment interest on Schedule A. But because William did not have enough investment income in those years against which to deduct the interest, the IRS disallowed the deductions and assessed accuracy-related penalties.
Issues: For taxpayers other than corporations, Sec. 163(d)(1) limits the amount allowed as a deduction for investment interest to the taxpayer's net investment income for the year. Sec. 163(d)(3)(A) defines investment interest as interest that is paid or accrued on...