Loan proceeds and passive activity losses.

• Author: Ellentuck, Albert B.
• Position: Case study

Editor's note: this case study has been adapted from "PPC Tax Planning Guide--Partnerships," 11th edition, by Grover A. Cleveland, William D. Klein, Terry W. Lovelace, Sara S. McMurrian, Linda A. Markwood and Richard d. Thorsen, published by Practitioners Publishing Company, Fort Worth, Tex., 1997.

Facts: Janis is a 60% partner in the JAX Partnership and materially participates in its operations. TAX is going to make two substantial purchases: (1) a large machine for use in the business (costing $ 100,000) and (2) land for investment, (also, costing $100,000). The partnership has the funds to pay cash for either the machine or the land (but not both), and will have to borrow the money for one of the purchases. Interest expense on the loan will be approximately $12,000 for each tax year. On her personal return, Janis shows interest income of $1,000 and a $75,000 guaranteed payment received for the use of capital. JAX pays no other interest and has ordinary income of approximately $50,000 per year (after deducting the guaranteed payment to Janis). JAX's tax adviser realizes that certain interest expense paid by a partnership must pass through to the partners as investment interest. Issues: Can the borrowed funds be used so that the passthrough of investment interest expense is minimized or eliminated? Is it preferable to use the borrowed funds to purchase the land or to purchase the machine, or does it make a difference?

Analysis

There are six different classifications of interest expense, and each requires different treatment on a partnership tax return:

1. Trade or business interest expense reduces the partnership's nonseparately stated ordinary income on page 1 of Form 1065, U.S. Partnership Return of Income.

2. Investment interest expense passes through as a separately stated item and is subject to limitation at the partner level.

3. Real estate rental interest expense reduces passive activity income from rental real estate.

4. Real estate rental interest expense from an activity in which the taxpayer is an "active" participant reduces passive activity income from rental real estate.

5. Other (non-real estate) rental interest expense reduces passive activity income from other rentals.

6. Partner interest expense passes through as a separately stated item to partners, who then determine the nature of the expense at the partner level.

The general rule is that the character of interest expense is determined by reference to the use of the debt...