Debt-Financed Distributions and Interest Tracing Rules
It’s been a slow news week, so let’s talk about a common concept to real estate investing: debt-financed distributions and interest tracing rules.
A debt-financed distribution occurs when a passthrough entity, such as a partnership, secures debt and then distributes a portion of the debt proceeds to its owners. Generally speaking, mortgage interest is deductible to the passthrough entity; however, the deductibility to the owner depends on the use of the debt-financed distribution.
In the late 1980’s, the IRS issued temporary guidance concerning the allocation of interest expense in connection with debt-financed distributions, promising at some subsequent date, to issue regulations on the matter. Thirty years later, let’s agree to stop holding our collective breath for those final regulations.
Under Temporary Regulations Sec. 1.163-8T and IRS Notice 89-35, there are two ways by which the debt proceeds and related interest expense may be allocated by the passthrough entity. The first is the general allocation rule, which allows for the allocation of the interest expense to be in accordance with each owner’s use of the debt proceeds. The second and more practical method, known as the optional allocation rule, permits the allocation of the distributed debt proceeds and the associated interest expense to one or more expenditures made during the same taxable year as the distribution.
The owner’s share of the passthrough entity’s interest expense on debt proceeds allocated to distributions to owners should be included on the “other deductions” line on the IRS Form 1065, Schedule K-1 and identified as “interest expense allocated to debt-financed distributions.”
If the received debt proceeds were used for income-producing activities or investments, the related interest expense to the owner is deductible. But, if the debt proceeds were used for items of personal in nature (i.e. buying a boat), then the related interest expense would not be deductible to the owner.
Source: IRS.gov, RIA Checkpoint
- Carey M. Heyman, CPA
- Managing Principal of Industry - Real Estate
- CliftonLarsonAllen LLP
- Century City (Los Angeles)
Carey is the Managing Principal of the Real Estate Industry at CLA. He is a trusted advisor with close to 20 years of experience providing accounting, assurance, tax, and consulting services to real estate industry owners, operators, family offices, developers and syndicators. Carey has a strong track record of helping clients build and retain capital by leveraging tax- and cost-saving strategies and employing tax credits and incentives. He also consults with high net worth individuals, large family groups, and owners of closely-held businesses on all aspects of tax planning, estate planning, and retirement planning.
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