Maximizing your Deductions Related to Debt-Financed Distributions
Did you know that there are tracking requirements when you receive proceeds from a cash-out refinancing of real estate owned directly or indirectly through a pass-through entity (i.e. LLC, partnership or S corporation)? This article will provide an explanation of the tax ramifications of interest expense allocable to refinance proceeds.
Generally, the receipt of proceeds from real estate financing is a nontaxable event due to the fact that the borrowing must be repaid. However, the income tax treatment of the interest expense associated with the refinance proceeds is dependent upon how the proceeds are utilized. The IRS has established “interest tracing” rules that govern the characterization of interest incurred on debt financing. The following provides the guidelines in applying the interest tracing rules:
- Interest traced to personal matters is non-deductible. For example, a taxpayer borrows on credit cards to take a personal vacation in Hawaii. The interest incurred on the credit card debt associated with the vacation would not represent tax deductible interest because the vacation itself does not represent a business or a production of income that would be taxable.
- Interest traced to a bank or brokerage investment account which does not hold tax exempt securities will represent investment interest expense. Investment interest expense is deductible as an itemized deduction but is limited annually to the taxpayer’s aggregate income from interest, dividends and capital gains. Any investment interest expense which is limited carries forward continuously. Care should be taken to not invest proceeds into tax exempt investments. This will negate the deductibility of the traced interest expense.
- Interest traced to a trade or business is deductible as an ordinary trade or business expense relating to the trade or business to which it is being allocated.
- Interest traced to the acquisition of a rental property is deductible as a rental expense.
- Interest traced to the pay-off of another loan will be treated consistent with the character of the interest on the loan paid off. However, if the proceeds are used to pay down a loan on a principal residence, the interest would not be deductible because the loan is not secured by the residence.
To limit audit risk, should the interest deduction be challenged under audit, the refinance proceeds must be tracked carefully and records should be retained to prove the audit trail. The record keeping can be facilitated by depositing such funds to a separate account not commingled with other funds. It is then critical that the funds be expended from this account towards investments which will characterize the interest incurred on such funds as tax deductible with the least amount of limitations.
We are not always made aware of our clients financing transactions because they are perceived to have no income tax implications. We encourage you to reach out to us to assist with any of your planning needs to maximize your interest deduction related to your debt-financed distributions or to discuss how to convert non-deductible interest into tax deductible interest.
For more information about maximizing deductions related to debt-financed distributions, please contact our office at (949) 260-1430.
Written by Katie Fickling
SKINNER FOUCH & OLSON LLP