15.12 Earmarking Use of Loan Proceeds For Investment or Business

The IRS has set down complex record keeping and allocation rules for claiming interest deductions on loans used for business or investment purposes, or for passive activities. The rules deal primarily with the use of loan proceeds for more than one purpose and the commingling of loan proceeds in an account with unborrowed funds. The thrust of the rules is to base deductibility of interest on the use of the borrowed funds. The allocation rules do not affect mortgage interest deductions on loans secured by a qualifying first or second home (15.1).

Keep separate accounts for business, personal, and investment borrowing. For example, if you borrow for investment purposes, keep the proceeds of the loan in a separate account and use the proceeds only for investment purposes. Do not use the funds to pay for personal expenses; interest is not deductible on personal loans other than qualifying student loans (Chapter 33). Furthermore, do not deposit loan proceeds in an account funded with unborrowed money, unless you intend to use the proceeds within 30 days of the deposit. By following these directions, you can identify your use of the proceeds with a specific expenditure, such as for investment, personal, or business purposes, and the interest on the loan may be treated as incurred for that purpose. The 30-day rule is discussed below.

Planning Reminder

Keep Loans Separate

To safeguard your investment and business interest deductions, you must earmark and keep a record of your loans. You should avoid using loan proceeds to fund different types of expenditures.

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The IRS treats undisbursed loan proceeds deposited in an account as investment property, even though the account does not bear interest. When proceeds are disbursed from the account, the use of the proceeds determines how interest is treated; see Examples 1 and 2 below.

30-day disbursement rule.

If you deposit borrowed funds in an account with unborrowed funds, a special 30-day rule allows you to treat payments from the account as made from the loan proceeds. Where you make more than one disbursement from such an account, you may treat any expenses paid within 30 days before or after deposit of the loan proceeds as if made from the loan proceeds. Thus, you may allocate interest on the loan to that disbursement, even if earlier payments from the account have been made; see Example 3 below. If you make the disbursement after 30 days, the IRS requires you to allocate interest on the loan to the first disbursement; see Example 4 below. Furthermore, if an account includes only loan proceeds and interest earned on the proceeds, disbursements may be allocated first to the interest income and then to the loan proceeds.

Allocation period.

Interest is allocated to an expenditure for the period beginning on the date the loan proceeds are used or treated as used and ending on the earlier of either the date the debt is repaid or the date it is reallocated.

Accrued interest is treated as a debt until it is paid, and any interest accruing on unpaid interest is allocated in the same manner as the unpaid interest is allocated. Compound interest accruing on such debt, other than compound interest accruing on interest that accrued before the beginning of the year, may be allocated between the original expenditure and any new expenditure from the same account on a straight-line basis. That is done by allocating an equal amount of such interest expense to each day during the taxable year. In addition, you may treat a year as twelve 30-day months for purposes of allocating interest on a straight-line basis.

Payments from a checking account.

A disbursement from a checking account is treated as made at the time the check is written on the account, provided the check is delivered or mailed to the payee within a reasonable period after the writing of the check. You may treat checks written on the same day as written in any order. A check is presumed to be written on the date appearing on the check and to be delivered or mailed to the payee within a reasonable period thereafter. However, the presumption may not apply if the check does not clear within a reasonable period after the date appearing on the check.

Planning Reminder

Using Borrowed Funds To Pay Investment or Business Interest

To get an interest deduction you must pay the interest; you may not claim a deduction by having the creditor add the interest to the debt. If you do not have funds to pay the interest, you may borrow money to pay the interest. The borrowed funds must be from a different creditor. The IRS disallows deductions where a debtor borrows from the same creditor to make interest payments on an earlier loan. The second loan is considered a device for getting an interest expense deduction without actually making payments. The Tax Court and several federal appeals courts have sided with the IRS.

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Change in use of property.

You must reallocate interest if you convert debt-financed property to a different use; for example, when you buy a business auto with an installment loan, interest paid on the auto is business interest, but if during the year you convert the auto to personal use, interest paid after the conversion is personal interest.

Order of repayment.

If you used loan proceeds to repay several different kinds of debt, the debts being repaid are assumed to be repaid in the following order: (1) personal debt; (2) investment debt and passive activity debt other than active real estate debt; (3) debt from a real estate activity in which you actively participate; (4) former passive activity debt; and (5) business debt. See Example 5 below. Payments made on the same day may be treated as made in any order.