Real property owners are often able to refinance appreciated property and obtain loan proceeds above the prior loan payoff. When a flow through entity (a partnership or S-corporation) distributes the excess loan proceeds to its owners (members or shareholders), the distribution is subject to debt financed distribution rules.
The IRS requires the recipients of the distribution to trace their use of the funds received to determine if the related interest expense incurred by the entity is deductible by the owner. It is the responsibility of the entity to trace the use of the funds and determine if the interest is deductible on the owner’s tax return.
The debt financed distribution rules have some leeway in the determination of the interest subject to tracing by the owners. For example, some of the excess debt proceeds can be allocated to operating expenses. Conversely, some of the distributions could be sourced from the property rental income. The Treasury Regulations §1.163-8T provide some guidance to determine the amount of the debt financed distribution.
The interest tracing rules are complex. Further, depending upon the activity at the entity level, there may be exceptions to the tracing rules explained above. Finally, real estate owners should be reminded that debt-financed distributions typically result in a scenario where upon the future sale of the property could result in gain recognition but with potentially little or no cash received (as the proceeds will be required to pay off the debt incurred to make the distributions).
The entity is only responsible to separately state the interest attributable to the distribution on the Schedule K-1. The individual owner is responsible for the determination of the treatment of the interest expense.
For tax purposes, interest expense falls into one of four types:
Passive activity use: If the owner used the distribution to invest in other rental property or a business in which he did not materially participate, the interest would be subject to same rules governing all passive activities.
Active trade or business use: The owner’s use of the funds could qualify as active trade or business use. For example, assume the owner used the distribution to purchase equipment in a business in which he was the sole proprietor. The interest expense related to the partnership distribution would then be fully deductible on the owner’s schedule C.
Investment use: If the owner used the distribution to make an investment, such as to purchase publically traded stock or bonds, the interest would be considered investment interest expense.
Personal use: If the use of the proceeds does not fit into any of the three categories above, it most likely falls under the definition of personal interest. Personal interest is not deductible. For example, if the owner uses the distribution to purchase a boat or payoff personal debt, the interest expense would be considered personal interest and would not be deductible.
Please contact your KS-LLP advisor for additional information or guidance about these rules.