Table of Contents
This chapter discusses the tax treatment of business interest expense. Business interest expense is an amount charged for the use of money you borrowed for business activities.
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Allocation of interest
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Interest you can deduct
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Interest you cannot deduct
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Capitalization of interest
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When to deduct interest
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Below-market loans
Publication
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537 Installment Sales
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550 Investment Income and Expenses
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936 Home Mortgage Interest Deduction
Form (and Instructions)
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Sch A (Form 1040)
Itemized Deductions -
Sch E (Form 1040)
Supplemental Income and Loss -
Sch K-1 (Form 1065)
Partner's Share of Income, Deductions, Credits, etc. -
Sch K-1 (Form 1120S)
Shareholder's Share of Income, Deductions, Credits, etc. -
1098
Mortgage Interest Statement -
3115
Application for Change in Accounting Method -
4952
Investment Interest Expense Deduction -
8582
Passive Activity Loss Limitations
See chapter 12 for information about getting publications and forms.
The rules for deducting interest vary, depending on whether the loan proceeds are used for business, personal, or investment activities. If you use the proceeds of a loan for more than one type of expense, you must make an allocation to determine the interest for each use of the loan's proceeds.
Allocate your interest expense to the following categories.
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Nonpassive trade or business activity interest
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Passive trade or business activity interest
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Investment interest
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Portfolio interest
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Personal interest
In general, you allocate interest on a loan the same way you allocate the loan proceeds. You allocate loan proceeds by tracing disbursements to specific uses.
The easiest way to trace disbursements to specific uses is to keep the proceeds of a particular loan separate from any other funds.
Example.
You secure a loan with property used in your business. You use the loan proceeds to buy an automobile for personal use. You must allocate interest expense on the loan to personal use (purchase of the automobile) even though the loan is secured by business property.
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The date the loan is repaid.
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The date the loan is reallocated to another use.
Example.
Connie, a calendar-year taxpayer, borrows $100,000 on January 4 and immediately uses the proceeds to open a checking account. No other amounts are deposited in the account during the year and no part of the loan principal is repaid during the year. On April 2, Connie uses $20,000 from the checking account for a passive activity expenditure. On September 4, Connie uses an additional $40,000 from the account for personal purposes.
Under the interest allocation rules, the entire $100,000 loan is treated as property held for investment for the period from January 4 through April 1. From April 2 through September 3, Connie must treat $20,000 of the loan as used in the passive activity and $80,000 of the loan as property held for investment. From September 4 through December 31, she must treat $40,000 of the loan as used for personal purposes, $20,000 as used in the passive activity, and $40,000 as property held for investment.
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Any unborrowed amounts held in the same account.
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Any amounts deposited after these loan proceeds.
Example.
On January 9, Edith opened a checking account, depositing $500 of the proceeds of Loan A and $1,000 of unborrowed funds. The following table shows the transactions in her account during the tax year.
Date | Transaction |
January 9 |
$500 proceeds of Loan A and
$1,000 unborrowed funds deposited |
January 13 |
$500 proceeds of Loan B
deposited |
February 18 | $800 used for personal purposes |
February 27 | $700 used for passive activity |
June 19 |
$1,000 proceeds of Loan C
deposited |
November 20 | $800 used for an investment |
December 18 | $600 used for personal purposes |
Edith treats the $800 used for personal purposes as made from the $500 proceeds of Loan A and $300 of the proceeds of Loan B. She treats the $700 used for a passive activity as made from the remaining $200 proceeds of Loan B and $500 of unborrowed funds. She treats the $800 used for an investment as made entirely from the proceeds of Loan C. She treats the $600 used for personal purposes as made from the remaining $200 proceeds of Loan C and $400 of unborrowed funds.
For the periods during which loan proceeds are held in the account, Edith treats them as property held for investment.
Example.
Frank gets a loan of $1,000 on August 4 and receives the proceeds in cash. Frank deposits $1,500 in an account on August 18 and on August 28 writes a check on the account for a passive activity expense. Also, Frank deposits his paycheck, deposits other loan proceeds, and pays his bills during the same period. Regardless of these other transactions, Frank can treat $1,000 of the deposit he made on August 18 as being paid on August 4 from the loan proceeds. In addition, Frank can treat the passive activity expense he paid on August 28 as made from the $1,000 loan proceeds treated as deposited in the account.
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The first day of that month.
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The date the loan proceeds are deposited in the account.
Example.
You borrowed $20,000 and used the proceeds of this loan to open a new savings account. When the account had earned interest of $867, you withdrew $20,000 for personal purposes. You can treat the withdrawal as coming first from the interest earned on the account, $867, and then from the loan proceeds, $19,133 ($20,000 - $867). All the interest charged on the loan from the time it was deposited in the account until the time of the withdrawal is investment interest expense. The interest charged on the part of the proceeds used for personal purposes ($19,133) from the time you withdrew it until you either repay it or reallocate it to another use is personal interest expense. The interest charged on the loan proceeds you left in the account ($867) continues to be investment interest expense until you either repay it or reallocate it to another use.
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Personal use.
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Investments and passive activities (other than those included in (3)).
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Passive activities in connection with a rental real estate activity in which you actively participate.
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Former passive activities.
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Trade or business use and expenses for certain low-income housing projects.
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Treat all borrowed funds on which interest accrues at the same fixed or variable rate as a single loan.
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Treat borrowed funds or parts of borrowed funds on which interest accrues at different fixed or variable rates as different loans. Treat these loans as repaid in the order shown on the loan agreement.
You can generally deduct as a business expense all interest you pay or accrue during the tax year on debts related to your trade or business. Interest relates to your trade or business if you use the proceeds of the loan for a trade or business expense. It does not matter what type of property secures the loan. You can deduct interest on a debt only if you meet all the following requirements.
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You are legally liable for that debt.
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Both you and the lender intend that the debt be repaid.
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You and the lender have a true debtor-creditor relationship.
You generally deduct OID over the term of the loan. Figure the amount to deduct each year using the constant-yield method, unless the OID on the loan is de minimis.
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On a constant-yield basis over the term of the loan.
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On a straight-line basis over the term of the loan.
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In proportion to stated interest payments.
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In its entirety at maturity of the loan.
Example.
On January 1, 2007, you took out a $100,000 discounted loan and received $98,500 in proceeds. The loan will mature on January 1, 2017 (a 10-year term), and the $100,000 principal is payable on that date. Interest of $10,000 is payable on January 1 of each year, beginning January 1, 2008. The $1,500 OID on the loan is de minimis because it is less than $2,500 ($100,000 × .0025 × 10). You choose to deduct the OID on a straight-line basis over the term of the loan. Beginning in 2007, you can deduct $150 each year for 10 years.
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Determine the issue price of the loan. Generally, this equals the proceeds of the loan. If you paid points on the loan (as discussed later), the issue price generally is the difference between the proceeds and the points.
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Multiply the result in (1) by the yield to maturity.
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Subtract any qualified stated interest payments from the result in (2). This is the OID you can deduct in the first year.
Example.
The facts are the same as in the previous example, except that you deduct the OID on a constant yield basis over the term of the loan. The yield to maturity on your loan is 10.2467%, compounded annually. For 2007, you can deduct $93 [($98,500 × .102467) - $10,000]. For 2008, you can deduct $103 [($98,593 × .102467) - $10,000].
If you refinance with the original lender, you generally cannot deduct the remaining OID in the year in which the refinancing occurs, but you may be able to deduct it over the term of the new mortgage or loan. See Interest paid with funds borrowed from original lender under Interest You Cannot Deduct, later.
The points reduce the issue price of the loan and result in original issue discount, deductible as explained in the preceding discussion.
Certain interest payments cannot be deducted. In addition, certain other expenses that may seem to be interest are not, and you cannot deduct them as interest.
You cannot currently deduct interest that must be capitalized, and you generally cannot deduct personal interest.
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Five individuals.
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The lesser of 5% of the total officers and employees of the company or 20 individuals.
Under the uniform capitalization rules, you generally must capitalize interest on debt equal to your expenditures to produce real property or certain tangible personal property. The property must be produced by you for use in your trade or business or for sale to customers. You cannot capitalize interest related to property that you acquire in any other manner.
Interest you paid or incurred during the production period must be capitalized if the property produced is designated property. Designated property is any of the following.
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Real property.
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Tangible personal property with a class life of 20 years or more.
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Tangible personal property with an estimated production period of more than 2 years.
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Tangible personal property with an estimated production period of more than 1 year if the estimated cost of production is more than $1 million.
If the uniform capitalization rules, discussed under Capitalization of Interest, earlier, do not apply to you, deduct interest as follows.
If you receive a below-market gift or demand loan and use the proceeds in your trade or business, you may be able to deduct the forgone interest. See Treatment of gift and demand loans later in this discussion.
A below-market loan is a loan on which no interest is charged or on which interest is charged at a rate below the applicable federal rate. A gift or demand loan that is a below-market loan generally is considered an arm's-length transaction in which you, the borrower, are considered as having received both the following.
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A loan in exchange for a note that requires the payment of interest at the applicable federal rate.
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An additional payment in an amount equal to the forgone interest.
The additional payment is treated as a gift, dividend, contribution to capital, payment of compensation, or other payment, depending on the substance of the transaction.
For any period, forgone interest is:
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The interest that would be payable for that period if interest accrued on the loan at the applicable federal rate and was payable annually on December 31,
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Any interest actually payable on the loan for the period.
Applicable federal rates are published by the IRS each month in the Internal Revenue Bulletin. Internal Revenue Bulletins are available on the IRS web site at www.irs.gov/irb. You can also contact an IRS office to get these rates.
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Gift loans (below-market loans where the forgone interest is in the nature of a gift).
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Compensation-related loans (below-market loans between an employer and an employee or between an independent contractor and a person for whom the contractor provides services).
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Corporation-shareholder loans.
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Tax avoidance loans (below-market loans where the avoidance of federal tax is one of the main purposes of the interest arrangement).
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Loans to qualified continuing care facilities under a continuing care contract (made after October 11, 1985).
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Gift loans between individuals if the loan is not directly used to buy or carry income-producing assets.
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Compensation-related loans or corporation-shareholder loans if the avoidance of any federal tax is not a principal purpose of the interest arrangement.
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Loans made available by lenders to the general public on the same terms and conditions that are consistent with the lender's customary business practices.
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Loans subsidized by a federal, state, or municipal government that are made available under a program of general application to the public.
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Certain employee-relocation loans.
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Certain loans to or from a foreign person, unless the interest income would be effectively connected with the conduct of a U.S. trade or business and not exempt from U.S. tax under an income tax treaty.
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Any other loan if the taxpayer can show that the interest arrangement has no significant effect on the federal tax liability of the lender or the borrower. Whether an interest arrangement has a significant effect on the federal tax liability of the lender or the borrower will be determined by all the facts and circumstances. Consider all the following factors.
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Whether items of income and deduction generated by the loan offset each other.
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The amount of the items.
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The cost of complying with the below-market loan provisions if they were to apply.
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Any reasons, other than taxes, for structuring the transaction as a below-market loan.
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A qualified continuing care facility is one or more facilities (excluding nursing homes) meeting the requirements listed below.
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Designed to provide services under continuing care contracts (defined below).
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Includes an independent living unit, and either an assisted living or nursing facility, or both.
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Substantially all of the independent living unit residents are covered by continuing care contracts.
A continuing care contract is a written contract between an individual and a qualified continuing care facility that includes all of the following conditions.
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The individual or individual's spouse must be entitled to use the facility for the rest of their life or lives.
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The individual or individual's spouse will be provided with housing, as appropriate for the health of the individual or individual's spouse in an:
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independent living unit (which has additional available facilities outside the unit for the provision of meals and other personal care), and
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assisted living or nursing facility available in the continuing care facility.
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The individual or individual's spouse will be provided with assisted living or nursing care available in the continuing care facility, as required for the health of the individual or the individual's spouse.
For more information, see section 7872(h) of the Internal Revenue Code.
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