Interest Tracking Rules and Debt-Funded Distributions

Much has been said recently about the “Buy, Borrow, Die” tax-free wealth creation strategy. The concept is quite simple.

First, you buy an asset that will appreciate, and you hold it as it appreciates. Since you need money to live on, you refinance instead of selling the asset. Taking out a loan is a non-taxable event, unlike selling the asset. Now comes my least favorite step in this process: if you die while owning an asset that is appreciating in value, the owner and his or her estate will never pay tax on the appreciation of that asset. The owner’s estate and/or beneficiaries get an increase in market value on the date of death or the six-month alternate valuation date, and the estate can sell the asset with no tax gain or with a minimum income tax at that time. Although it may be tax efficient, we do not recommend death as a planning technique.

The strategy works well, but it can lead to some tax complications, especially when the assets you own are held in flow-through entities for federal income tax purposes.

This article does not consider any additional complexity related to IRC Sec. 163(j) interest limits which may further complicate these rules. Please consult your tax advisor if you are subject to these limitations. The distribution of financing proceeds may also have implications for the gain realized on a sale or trade of the property, including in a deed in lieu of foreclosure or foreclosure scenario.

Interest Tracking Rules

Taking out a loan would not result in the payment of taxes, but would result in the payment of interest on the principal balance of the loan. Section 1.163-8T of the Income Tax Regulations provides that the deductibility of interest on debt is determined by associating debt proceeds with specific expenditures made, and the nature of those expenditures determines the deductibility of interest. . Deductibility is not based on what the loan is secured by.

For example, if you have an investment account with stocks and bonds and you take out a margin loan on that account to pay for personal expenses, the interest deductibility on that loan would be attributed to personal expenses and would not be deductible. . .

Debt funded distribution interest

Assuming you have a flow-through entity that owns an asset that has appreciated in value: if the flow-through entity refinances or originates a loan inside the flow-through entity secured by the appreciated asset and then distributes the proceeds in additional cash to the owners of the entity, you could have what the IRS would call a debt-financed distribution.

Based on the interest traceability rules mentioned above, the deductibility of any interest related to distributed debt proceeds must be tied to what the proceeds were used to purchase. In the case of a flow-through entity, the entity would not be able to determine what the proceeds were used for after it was distributed to the owners, so the flow-through entity would report any related interest expense proceeds distributed separately under other deductions, and the owner should determine the deductibility of such interest expense.

For example, Partnership P refinances a $10,000,000 loan and $7,000,000 was used to repay the original loan to purchase the appreciated asset. $250,000 was used to pay borrowing costs for the refinancing and the remaining $2,750,000 was distributed to the owners of the entities. In this example, under the general interest allocation rules, 72.5% of the loan proceeds would be allocated to rental or ordinary income based on a link to the old loan and loan costs. The remaining 27.5% would be reported separately as leveraged distribution proceeds; the interest on which would be shown separately on the owners’ K-1s. The deductibility of this additional interest (or lack thereof) would be based on how this money was spent by the owners. If the owners took the distribution and contributed to the equity proceeds of another business or rental property, that interest would potentially be deductible as an ordinary or rental expense. If the owner invested the distributed proceeds in stocks or bonds, the interest could be considered an investment interest expense on Schedule A of their personal statements, and if the owners used the proceeds for expenses personal, interest charges may be non-deductible interest.

Optional allocation rule

There is an optional allocation rule whereby the flow-through entity may allocate debt proceeds to all cash expenditures other than distributions made in the same tax year as the distribution. This means that for our example, if P has a loan of $10,000,000 and $7,000,000 of that proceeds went to repay the original loan, $250,000 went to loan costs and P got $750,000. additional cash expenditures in the tax year for capital assets or expenses, then the amount allocated as debt-financed distributions would only be $2,000,000. If you distributed the same $2,750,000 of the proceeds after loan costs, then only $2,000,000 or 20% of the interest is initially allocated to debt-financed distribution interest and 80% could be allocated to investment expenses. business or rental.

30 day rule

There is a rule that if expenses occur 30 days before or after debt proceeds are received, you can consider that proceeds to be related to those expenses and you would potentially not need to allocate them to debt proceeds. debt-financed distribution. This could be useful if you have a refinance of a loan at the beginning or end of the year and have deployed capital within 30 days but in a different tax year.

Refund rule

Whether you use general interest tracking or choose the optional allocation rule or the 30-day rule, under paragraph (d) of Article 1.163-8T, the flow-through entity is able to reduce the principal allocated to distributions first when the loan is repaid. For example, if the loan allocation was originally $8,000,000 for lease and $2,000,000 for debt-financed distributions at the end of the previous year, and $1,000,000 of principal are repaid equally throughout the current tax year, the average balances of the two allocated portions of the loans would be $8,000,000 and $1,500,000 for the current tax year. Therefore, only 15.8% of interest would be allocated to debt-funded distributions (1,500,000/9,500,000 = 15.8%), and this percentage would decrease each year as the debt-funded distribution allocation loan debt is repaid first.

Conclusion

Borrowing money against appreciated assets and taking the money for personal expenses or other business investments is a very useful tax planning tool and can result in significant asset growth. There are certain tax complexities and potentially non-deductible interest charges that you should be aware of. Always consult competent tax professionals to stay compliant with these rules while maximizing your deductions.

Sharon D. Cole