PORTFOLIO

Interest Expense Deductions (Portfolio 536)

Tax Management Portfolio, Interest Expense Deductions, No. 536-4th, describes in detail the basic rules relating to the allowance of and limitations on deductions for interest expenses as set forth in the Internal Revenue Code and Treasury Regulations. Coverage includes: (1) the determination of whether payments are interest in form but not in substance, or vice versa; (2) the measurement and timing of interest deductions; (3) the investment interest limitation; (4) the nondeductibility of personal interest, including the “qualified residence interest” exception; (5) the various provisions for imputation of interest, including imputation of interest on certain types of below-market loans; (6) the interest capitalization rules; and (7) a survey of provisions disallowing interest.

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DESCRIPTION

Tax Management Portfolio, Interest Expense Deductions, No. 536-4th, describes in detail the basic rules relating to the allowance of and limitations on deductions for interest expenses as set forth in the Internal Revenue Code and Treasury Regulations. Coverage includes: (1) the determination of whether payments are interest in form but not in substance, or vice versa; (2) the measurement and timing of interest deductions; (3) the investment interest limitation; (4) the nondeductibility of personal interest, including the “qualified residence interest” exception; (5) the various provisions for imputation of interest, including imputation of interest on certain types of below-market loans; (6) the interest capitalization rules; and (7) a survey of provisions disallowing interest.


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AUTHORS

DOMINIC L. DAHER
Dominic L. Daher is the Director of Internal Audit and Tax Compliance for the University of San Francisco. Mr. Daher also serves as an Adjunct Professor of Law in the University of San Francisco's School of Law, where he teaches Federal Income Taxation, Accounting for Lawyers, and Law Practice Management: A Pathway to Success. In May 2005, Mr. Daher garnered the Outstanding Faculty of the Year Award. Mr. Daher serves on the editorial advisory boards for the some of the leading tax and accounting publications in the country. Mr. Daher is the author (or co-author) of over 40 published articles and 10 books which deal with various aspects of federal tax law and nonprofit accounting issues, including one which has been cited in a report to the United States Congress by the National Taxpayer Advocate. Among his many other accolades, Mr. Daher is the co-author of a leading treatise on federal tax law, The Hornbook on the Law of Federal Income Taxation (Thomson West 2008), which has been cited in numerous decisions by various Federal Circuit Courts of Appeals. Mr. Daher holds a Master of Laws in Taxation from New York University School of Law (where he served as the Graduate Editor of the Environmental Law Review); a Juris Doctor from Washington University School of Law (where he was the Judge Myron D. Mills Scholar); and both Master and Bachelor of Accountancy degrees from the University of Missouri-Columbia (where he was a merit scholar and graduated with honors).

TABLE OF CONTENTS

Detailed Analysis

I. Introduction

II. Outline of Legislative History

A. Early History

B. The 1984 Act and the Time Value of Money

C. The Tax Reform Act of 1986

D. Post Tax Reform Act of 1986 Legislation

III. What Is “Interest?”

A. In General

B. Is There Valid “Indebtedness?”

1. Necessity for an Indebtedness

2. Intrafamily Transactions

3. Nonrecourse Debt

4. “Sham Transaction” and Similar Doctrines

a. Introduction

b. Economic Substance, Business Purpose and Tax Avoidance

c. Knetsch and Related Cases

d. Suppose the Only Purpose Is Tax Avoidance?

C. Allocation of Payments to Interest and Principal

1. General Rule

2. Agreement

3. Lump-Sum Settlement

IV. Is It Interest in Form But Not in Substance?

A. Interest or Gift?

B. Interest or Profit-Sharing?

C. Interest or Purchase Price?

D. Interest or Payment for Services?

E. Interest or Dividend?

1. Tax Advantages of Debt Capitalization

a. Deduction of Interest Payments

b. Taxation of Principal Payments

2. A Question of Fact: Factors Considered

3. Section 385's Failure

F. Interest or Partnership Distribution?

G. Tax-Motivated Transactions

V. Is It Interest in Substance Although Not in Form?

Introductory Material

A. Mortgage Points

1. Paid by the Buyer

a. Case Law

b. Loan on Principal Residence

2. Paid by the Seller

B. Standby and Commitment Fees

C. Penalties

1. Prepayment Penalties

2. Late Payment Penalties

D. Statutory Mortgage Redemption Fee

E. Repurchase Premium

F. Sale-Leasebacks

G. Statutory Characterization as Interest

1. Redeemable Ground Rent

2. Stepped Rents, Etc.: Section 467

3. Foreign Currency Transactions: Section 988

4. Imputed Interest

VI. Accounting Issues

Introductory Material

A. Method of Accounting

1. Cash Basis Taxpayers

a. Payment

(1) In General

(2) Payment with Note

(a) Another's Note

(b) Own Note

(3) Payment by Increasing Debt

b. Prepaid Interest

c. OID Rules

2. Accrual-Basis Taxpayers

a. Accrued

b. Contingent Interest

c. Unlikelihood of Payment

d. The Economic Performance Requirement of Section 461(h)

(1) Rev. Rul. 83-84

(2) Section 461(h)

e. Regs. Section 1.446-2

f. Recapture on Corporate Liquidation

B. Capitalization

1. Interest Required to Be Capitalized Under Section 263A(f)

a. Introduction

b. Detailed Statutory Explanation

c. Basic Interest Capitalization Rules

d. Rules Pertaining to Real Property

(1) Introduction

(2) Definition of Real Property

(3) The “Unit” of Property

(4) “Production,” the “Production Period” and the Suspension Rule

(a) In General

(b) Suspension of Production Period

e. The “Avoided Cost Method:” Basic Mechanics

(1) In General

(2) Computation Periods and Measurement Periods

(3) Accumulated Production Expenditures (“APE”)

(4) Indebtedness of the Taxpayer

(5) Determining the Interest to Be Capitalized

(a) Traced Debt Amount

(b) Interest “Paid or Incurred”

(c) Excess Expenditure Amount

(d) Examples

(e) Election Not to Trace Debt

(f) Use of an External Rate

f. Special Preemption Rules

(1) Code Provisions Preempted by Section 263A(f)

(2) Code Provisions that Preempt Section 263A(f)

(3) The Substitute Capitalization Method

(4) Examples

g. Rules Relating to Common Features

(1) Basic Rules

(2) Where Common Features Are Completed Before or After Benefited Property Is Sold or Placed in Service

(a) Introduction

(b) Common Feature Placed in Service Before the End of the Production Period of a Benefited Property

(c) Where Benefited Property Is Sold Before Production of a Common Feature Is Completed

(d) Where Benefited Property Placed in Service Before Production Completed on Common Feature

(e) Examples

h. Property Produced Under Contract

i. Property Produced by a Related Person

j. Deferred Intercompany Transactions

k. Simplified Inventory Method

l. Anti-Abuse Provisions

m. Miscellaneous

2. Section 266 Carrying Charges

a. Capitalizable Interest

(1) Unimproved and Unproductive Real Property

(2) Real Property Under Development or Improvement

(3) Personal Property

(4) Other Capitalizable Interest

b. How to Make the Election

C. Special Situations

1. Allocation Between Foreign and U.S.-Source Income

2. Interest on Margin Accounts

3. Straddles

VII. Who Is Paying the Interest?

A. In General

B. Utilization of “Dummy” or Nominee Corporations to Avoid Usury Laws

1. The “Wholly Owned” Debate

2. The Bollinger Resolution

C. Interest on Debts Secured Only by Property

1. Mortgages

2. Life Insurance Loans

D. Joint Obligors

E. Guarantors and/or Endorsers

F. Interest on Transferee Tax Liability

G. Cooperatives: Section 216

VIII. How Is Interest Classified?

A. Overview

B. Investment Interest

1. General Rule

2. “Investment Interest” Defined

3. “Property Held for Investment” Defined

4. “Net Investment Income” Defined

5. Persons to Whom Limitation Applies

6. The Distinction Between Investment Income and Portfolio Income

C. Passive Interest

D. Active Interest

E. What Is a “Qualified Residence?”

F. Married Couples Treated as One Taxpayer for Purposes of Qualified Residence Rules

G. Time-sharing Arrangements

H. Residences After Destruction

I. Qualified Residence Interest

1. “Acquisition Indebtedness”

a. In General

b. Notice 88-74

2. “Home Equity Indebtedness”

3. “Secured”

J. Interest Overcharge as Qualified Residence Interest

K. Estate Tax Extensions

L. Personal Interest

M. Student Loan Interest

N. Allocation Among Activities: Regs. 1.163-8T

1. In General

2. Allocation Period

3. Allocation Where Proceeds Are Not Disbursed to Borrower

4. Debt Proceeds Deposited in Borrower's Account

5. Debt Proceeds Received in Cash

6. Special Rules for Allocating Debt

7. Debt Repayments

8. Debt Refinancings

9. Reallocation of Debt

10. Coordination with Other Restrictions on Deduction of Interest

11. Pass-Through Entities

a. Debt-Financed Acquisitions

b. Debt-Financed Distributions

O. Itemized or “Above the Line” Deduction

IX. Imputed Interest

Introductory Material

A. Below-Market Loans: Section 7872

B. Original Issue Discount (OID)

1. General

2. Deductions for OID

3. OID on Debt Instrument Issued for Property

C. Bond Premium: Section 171

D. Section 483

E. Section 482

X. Special Statutory Disallowances and Deferrals

Introductory Material

A. Reduction of Itemized Deductions: Section 68

B. Loans from Qualified Plans: Section 72(p)

C. Investment Interest: Section 163(d)

D. “Registration-Required Obligations:” Section163(f)

1. Obligations that are “Not of a Type Offered to the Public”

2. Regs. 1.163-5(c)

E. High-Yield Discount Obligations: Section 163(i)

F. “Earnings Stripping:” Section 163(j)

1. Introduction

2. Determining Whether There Is Any Exempt Related Person Interest Expense

a. General

b. Definition of Related Person

c. Exempt Recipient Requirement

3. Determining the Amount of Disqualified Interest

a. Debt

b. Equity

4. Determining Excess

a. Net Interest Expense: Determining Interest, Income and Expense

b. Determining Adjusted Taxable Income

5. Applying Section 163(j) Rules

6. Carryforwards

7. Affiliated Group Rules

a. General

b. Rules for Consolidated Groups

c. Rules for Affiliated Groups Other Than Consolidated Groups

d. Debt/Equity Ratio of Related Corporations Treated As One Taxpayer

e. Qualified Stock Purchases

f. Other Adjustments to Basis in Determining Equity

g. Limitations on Carryforward of Tax Attributes

8. Interest Expense Items

9. Foreign Corporations with Effectively Connected U.S. Income

10. Guarantees and Back-to-Back Loans

G. Interest on Estate Tax Deferred Under Section 6166: Section 163(k)

H. Interest Payable in Equity: Section 163(l)

I. Corporate Equity Reduction Transactions: Section 172(b)(1)(E)

J. Hobby Losses: Section 183

K. Insurance: Section 264

L. Interest Related to Tax-Exempt Income: Section 265

1. IRS Guidelines: In General

2. IRS Guidelines: Dealers

3. Short Sales

4. Financial Institutions

5. Rulings Policy

6. Section 265(a)(1): Exempt Income Other Than Interest

M. Section 267 Matching Rules

N. Corporate Acquisition Indebtedness: Section 279

1. Introduction

2. Rationale

3. Nuances of 279

a. Acquisition Purpose

(1) Is the Obligation “Issued to Provide Consideration” for an Acquisition?

(2) Stock Purchase

(3) Asset Purchase

b. Subordination

c. Convertibility

d. Financial Ratios

(1) Date of Computation and Effect of Evaluation

(2) Exceptions to Status

(a) Three-Year Rule

(b) Control Exception

(c) Five Percent Stock Rule

(3) Change in Nature or Ownership

(4) Financial Computations

(a) Debt/Equity

(b) Earnings/Interest

(5) Special Rules for Financial Institutions

e. Foreign Corporations

f. Affiliated Groups

4. Reporting

5. Planning Considerations

O. Interest Paid on Deposits, Etc.: Section 461(e)

P. At-Risk Limitation: Section 465

Q. Passive Activity Loss Limitation: Section 469

R. Interest Allocable to Accrued Discount

S. Order of Application of Rules

XI. Alternative Minimum Tax

XII. Tax Deficiency Interest

A. Status as Personal Interest

1. Income Taxes

2. Estate Tax

B. Effect of Taxpayer Contesting the Deficiency

1. Uncontested Liability

2. Contested Liability

3. Payment Before Resolution of Contest

C. Partial Payment

D. Amended Returns

E. Interest on Transferee Liabilities

F. Interest on Underpayments from Undisclosed Reportable Transactions

G. Abatement of Underpayment Interest


WORKING PAPERS

Working Papers

Table of Worksheets

Other Sources

Worksheet 1 Excerpts from Committee Reports to Accompany H.R. 3838 and General Explanation of the Tax Reform Act of 1986

Worksheet 2 Qualified Residence Interest Examples ( 163(h)(3))

Worksheet 3 Section 163(j) Examples

Worksheet 4 Investment Interest Expense Elections ( 163(d))

Bibliography

OFFICIAL

Statutes:

Treasury Regulations:

Public Laws:

Legislative History:

Treasury Procedures and Rulings:

Cases:

UNOFFICIAL

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