Planning and proper application of interest expense allocation

Jul 19, 2022

Key takeaways

Tracing the proceeds from the debt will determine the interest expense type and deductibility

Interest expense deductibility is not determined on how the funds are secured

Sufficient records are imperative to support interest expense deductions

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Interest is generally allowed as a deduction in computing taxable income for amounts paid or accrued in the taxable year. With changing provisions, as seen with the business interest expense limitations, understanding what types of interest are deductible and how to allocate the interest expense is key. Intuitively, when determining the deductibility of interest expense linking the funds to how they are secured may make sense. However, under the current rules, the interest expense allocation is determined by tracing funds to their use. Another way to say this is that debt will be categorized through tracing the disbursement of debt proceeds to specific expenditures. An expenditure made within 30 days before or after the proceeds are deposited in an account are treated as being made from those loan proceeds.

The IRS lays out six categories of expenditures to which interest can be traced: former passive activity, investment, passive activity, personal, portfolio, or trade or business. 

In all practicality, the expenditures can be re-thought of in five areas or types of interest based on how they are traced and they are:

5 types of Interest expense

Personal Interest

Credit card, vehicle, healthcare

Residential interest

Primary home, vacation home

Investment interest

Stocks, bonds, land

Passive interest

Trade or business in which the taxpayer does not materially participate

Trade or business interest

Trade or business in which the taxpayer does materially participate

Taxpayer A borrows $500,000 on Jan. 1 which is deposited into their checking account. The note is secured by the current primary residence. On April 1, $200,000 of the funds are used for improvements on their primary residence. With the remaining funds, $100,000 are used on July 1 to purchase shares of an S corporation and $200,000 are used on Sept. 1 to purchase an aircraft.

Interest tracing example:

Date of transaction

Allocation result

January 1

Full $500,000 of debt considered an investment expenditure

April 1

$200,000 of debt allocated to primary residence. Remaining $300,000 allocated to investment expenditure.

July 1

$100,000 of debt allocated to trade or business expenditure. $200,000 of the debt remains allocated to an investment expenditure.

September 1

$200,000 of the debt, and remaining funds, allocated to personal expenditure

The initial funds deposited into the checking account are an investment expenditure. The interest expense traced to the funds is investment interest expense. Each time the funds are used for an expenditure, a determination is required to re-allocate interest to the correct type.

Interest related to the $200,000 used to improve their primary residence will be allocated as residential interest. An interest expense deduction is allowed due to the carve-out for mortgage interest on debt of a primary and/or secondary home, up to $750,000 for debt incurred after Dec. 15, 2017. 

When tracing the $100,000 funds used to purchase S corporation shares, should the interest be allocated as trade or business or passive? This is an important determination that will need to be made and is fact-dependent in each situation. In this instance, presume that Taxpayer A materially participates in the activity of the S corporation. Interest expense related to this expenditure is allocated to the trade or business category.

The remaining $200,000 is used to purchase an aircraft. A decision will need to be made as to how to allocate the funds to the expenditure. In this case, it is determined that the aircraft is for personal use. Since the expenditure does not fall into the passive, trade or business, residential interest, or investment category, the interest related is personal interest and is nondeductible.

When funds are re-deployed and/or used, consideration and careful analysis is needed to support the allocation of the interest expense. The IRS may challenge the interest expense deduction by changing the allocation of the category that the interest is related to. The results of this reallocation can be significant. For example, if a trade or business deduction is taken in a given tax year and the IRS determines that the expense should have been passive, the expense is now subject to the passive activity limitation rules. Keep in mind that there are other limitations to deducting interest expense that will need to be considered after tracing the interest to the funds use.

How the funds are used will determine the type of interest deductible. Funds sitting in an account when deployed for use may change how the interest is allocated.

To help negate the possibility of a detrimental determination, it is recommended to have receipts and records readily available to support all allocations of interest expense. When planning on using debt proceeds, depositing the proceeds in separate accounts distinct from personal use, will help to support the allocation. Debt proceeds received directly by a third party are treated as the borrower having used the proceeds based on how the lender disbursed them.

The examples provided are not all-encompassing, and there are more complexities than discussed here. Contact your tax advisor if you have questions or want further explanation into the interest expense tracing rules.

RSM contributors