Case — Interest Tracing Rules

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TL Case Summ

THE QUESTION

Is accrued interest on a home loan deductible as investment interest if the taxpayer secures the loan by pledging corporate stock?

THE DISPUTE

Taxpayer Says: The accrued interest is deductible as investment interest to the extent it is not qualified residence interest and is attributable to the pledged stock.

Internal Revenue Service Says: The use of investment property to secure repayment of a loan has no effect on the allocation of the related debt and interest. The interest is not deductible investment interest.

THE LAW

From Internal Revenue Code Section 163(d)(1): Generally, investment interest is deductible up to the amount of net investment income.

From Internal Revenue Code Section 163(d)(3)(A): Investment interest is interest allowable as a deduction which is paid or accrued on indebtedness properly allocable to property held for investment.

From Temporary Federal Tax Regulation 1.163-8T(c)(1): Debt and interest are allocated to expenditures according to the use of the debt proceeds.

THE CAUSE OF THE DISPUTE

Whether or not you can deduct interest on your tax return generally depends on what you used the loan proceeds for. Interest is separated into categories, such as personal interest, which is nondeductible, and qualified residence interest and investment interest, which are deductible subject to certain limitations.

Under the interest tracing rules, debt is traced to what you purchased with the proceeds, and the interest you pay on the debt is allocated based on that use. In other words, if you buy an investment asset, the interest you pay on the debt is categorized as investment interest. Debt and the related interest can be allocated to more than one category.

In this case, the taxpayer purchased a home and financed the entire purchase with a loan. The home and shares of stock were used as collateral for the loan. When the loan was refinanced, only the home was used as collateral, though the taxpayer still owned the stock. Upon refinancing, the taxpayer deducted a portion of the interest accrued on the initial loan as investment interest because the stock securing that loan (to which the accrued interest was attributable) was investment property.

The IRS says the use of investment property as collateral for the loan has no bearing on the allocation of debt and interest. Instead, the allocation depends on how the debt proceeds were used – in this situation, for a home purchase. The interest is not deductible as investment interest.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 10KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS. The use of investment property to secure repayment of indebtedness has no effect on the allocation of debt and interest. Rather, it is the use of the debt proceeds that determines the allocation. No interest accrued on the initial loan is properly allocable to the stock as investment property. Editorial note: The full amount of the debt was allocated to the personal residence, and presumably was deductible (depending on the taxpayer’s circumstances) as qualified residence interest.
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