An interesting tax fact about interest is that the general rule is quite simple: “There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.”
The problem is that the simple general rule is followed by at least thirteen subsections, some including multiple paragraphs, subparagraphs, clauses, and subclauses, that establish limitations and exceptions to the general rule.
In Summary Opinion 2019-2 (Pugh), the taxpayer owned a sole proprietorship software development company. He had plans to expand the company, and in 2005 and 2006, he bought two vacant lots, one adjacent to land he already owned and the other directly across the street. He borrowed money to pay for the lots and paid interest on the loans during 2010 and 2011.
Later he purchased two steel buildings, disassembled them, and stored some of the components on one of the properties. His plan was to reassemble the buildings on the properties as shown on a site plan prepared by an architect in 2007. The taxpayer intended that the reassembled buildings would serve as the business headquarters.
Before the plan could be put into effect, the business lost a major customer, revenues sharply decreased, and some employees left. As of the date of trial, the lots, some of which were sold, remained undeveloped, and some of the components of the steel buildings were sold as scrap metal.
The taxpayer deducted the interest paid on the lot-purchase loans on his 2010 and 2011 federal income tax returns as business interest.
The IRS says the lots were never actually used in the taxpayer’s trade or business and should be considered property held for investment. That means interest paid on the loans was investment interest.
According to the IRS argument, since a deduction for investment interest is limited to the amount of investment income received, and the taxpayer did not have any investment income in 2010 or 2011, none of the interest is deductible.
Relevant tax law
From internal revenue code section 163(d): Provides that a taxpayer, other than a corporation, may deduct “investment interest” only to the extent of investment income. For purposes of section 163(d) and in general, “investment interest” means interest that is “paid or accrued on indebtedness properly allocable to property held for investment.”
From internal revenue code section 163(d)(5): In general, the term “property held for investment” shall include any property which produces income of a type described in section 469(e)(1), and any interest held by a taxpayer in an activity involving the conduct of a trade or business which is not a passive activity, and with respect to which the taxpayer does not materially participate.
From internal revenue code section 163(h): Provides that a taxpayer, other than a corporation, is not entitled to a deduction for personal interest. For purposes of section 163(h) “interest paid or accrued on indebtedness properly allocable to a trade or business” is generally deductible.
The tax court determined that the interest on the lots was not investment interest because the lots did not fit the definition of “investment property.” The court then turned to the question of whether the interest was deductible as trade or business interest.
Do you think the court agreed with the taxpayer that the interest was “allocable to a trade or business” and was therefore deductible?
Is investment interest still deductible under the new tax law?
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The court said:
The properties were not actually used in the taxpayer's trade or business during the years in issue.
Nevertheless, we are satisfied that the properties were certainly “allocable” to that business.
Consequently, the interest paid in connection with the indebtedness on the properties is not treated as personal interest.
The IRS does not suggest that any of the other exceptions or limitations to the general rule set forth in section 163(a) are applicable, and we are satisfied that none are.
That being so, we find that the taxpayer is entitled to the deduction claimed for mortgage interest for each of the years in issue.
We further find that because the deduction for each year is “allocable” to the taxpayer's trade or business, the deduction is properly taken into account in the computation of his adjusted gross income.
Taxpayers who itemize can still deduct interest on loans used to purchase investments that produce taxable income. As in the past, investment interest is limited—that is, deductible up to the amount of taxable investment income reported.
Note that from 2018 through 2025, miscellaneous itemized deductions are not deductible, and no investment expenses are deductible. That also means no investment expenses are deducted when calculating the investment interest deduction limit.
Investment interest in excess of net investment income is carried forward and treated as investment interest paid or accrued in the next year.