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Ezra Dyckman and Charles S. Nelson Ezra Dyckman and Charles S. Nelson

The characterization of interest expense as “business interest,” “investment interest,” or “personal interest” can have important tax consequences. However, many taxpayers are blissfully unaware of the tax treatment of interest expense if they use real estate refinancing proceeds to buy yachts or to make other personal expenses. A recent opinion issued by the U.S. Tax Court clarifies how the interest characterization rules work in the context of partnerships that have made debt-financed distributions to their partners.

Background

Under Section 163 of the Internal Revenue Code, the deductibility of interest expense varies depending on how it is characterized. Interest allocable to a trade or business is generally deductible (subject to the limitations of new Section 163(j)). However, investment interest is deductible only to the extent of the taxpayer’s investment income, and personal interest is generally not deductible at all. The characterization of interest expense is generally determined by tracing how the taxpayer used the proceeds of the underlying debt.

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