Treatment of investment interest expense allocable to partnership's trading activity.

• Author: Oberst, Timothy S.

Hedge funds are private investment partnerships that seek to maximize returns through active portfolio management rather than long-term capital appreciation. Their activities go beyond mere investing and constitute trading. The typical hedge fund Schedule K-1 discloses that the partnership's trading activities constitute a trade or business, and the distributive share items are not considered to be derived from a passive activity under Temp. Regs. Sec. 1.469-1T(e)(6). The K-1 will also instruct partners who do not materially participate in the partnership that the interest expense attributable to the partnership's trading activities is subject to the Sec. 163(d) investment interest limitation, and the allowable ordinary loss should be reported as nonpassive on Schedule E, Part II.

Until this year, the tax professionals preparing the individual returns of hedge fund investors who have followed this treatment of investment interest have had to rely on FSA 200111001. The conclusions of this field service advice are based on the statutory construction of Secs. 163 and 702 and temporary regulations under Sec. 469.

However, the IRS revisited the issue in 2008 with the release of Rev. Rul. 2008-12 on March 10 and the concurrent release of Announcement 2008-65 and Rev. Rul. 2008-38 on July 3. Together these rulings confirm the proper tax treatment of investment interest expense allocable to a partnership's trading activity.

Rev. Rul. 2008-12

The issue posed in Rev. Rul. 2008-12 is whether a noncorporate limited partner's distributive share of interest expense incurred in the trade or business of trading securities by the partnership is subject to the Sec. 163(d) limitation on the deduction of investment interest. The facts are that an entity taxable as a partnership is engaged in the trade or business of trading securities for its own account and incurs indebtedness in its trading activities. LP is a noncorporate limited partner who does not materially participate in the partnership's trading activity, and LP's distributive share of partnership items includes interest expense on indebtedness incurred in the partnership's trading business.

The analysis of Rev. Rul. 2008-12 for the most part follows that of FSA 200111001, although the ruling does not refer to the latter. The deductibility of interest expense is governed by Sec. 163. Under Sec. 163(d)(1), the deduction for investment interest for noncorporate taxpayers is limited to the amount of net...