The Tax Court held in Lipnick v. Commissioner (No. 1262-18)
that a taxpayer who inherited or received as a gift interests in partnerships from his father was not subject to the same investment interest characterization because he never received any debt-financed distribution proceeds from the partnerships. As a result, allocations of interest expense to the taxpayer from the partnerships were permitted to be treated as indebtedness properly allocable to the partnerships’ real estate assets and thus applied to offset the associated real estate income.
, the taxpayer’s father was a partner in various partnerships that owned and operated rental real estate. Between 2009 and 2012, several of the partnerships borrowed money from a third party and distributed the proceeds to the father as debt-financed distributions. The cash received by the father was invested in money market funds and other investment assets. The father reported his distributive shares of the interest expense as investment interest in Schedule A of his federal income tax return.
In 2011, the taxpayer received an interest in one partnership from his father via a gift. Then, upon the father’s death in 2013, the taxpayer received certain direct and indirect interests in another partnership. The taxpayer took the position that since he had not received any of the loan proceeds, and had not used any partnership distributions to acquire investment assets, the interest paid by the partnerships was not investment interest, as it had been to his father. Instead, he treated the interest as properly allocable to the partnerships’ assets, hence fully deductible against his share of the partnerships’ real estate income.
For the years in issue (2013 and 2014), the IRS determined that the taxpayer’s distributive shares of the interest paid by the partnerships with respect to the loans should be reported as investment interest. Under Section 163(d)(1), investment interest is deductible only to the extent of a taxpayer’s net investment income. Because the taxpayer had insufficient investment income for the years in question, the IRS disallowed the entire interest deduction reported.
The Tax Court examined Temp. Treas. Reg. Sec. 1.163-8T(c)(1), which provides a tracing rule for determining when debt is properly allocable to property held for investment. The court noted that this regulation does not specify how the tracing rules apply to partnerships and their partners, and explained that the Notice 89-35 provides guidance on this point. The notice provides that if a partnership makes a debt-financed distribution to its partners, each partner’s use of the proceeds governs whether the interest passed through to him constitutes investment interest. Thus, if a partner uses the proceeds distributed to him by the partnership to acquire property he holds for investment, the corresponding interest expense passed on to him by the partnership will be treated as investment expense.
The Tax Court noted that Notice 89-35 refers to the scenario in this case as a debt-financed acquisition as opposed to a debt-financed distribution, and for purchases of an interest in a pass-through entity (other than via a contribution to the capital thereof), debt proceeds and associated interest expense are to be allocated among all the assets using any reasonable method. The court then concluded that the taxpayer is treated as having made a debt-financed acquisition of the partnership interests that the taxpayer acquired from his father. In that regard, the Tax Court rejected the IRS’s contention that the taxpayer did not assume a debt or take property subject to a debt and the IRS’s emphasis that the taxpayer had no personal liability on the loans. The court explained that the taxpayer essentially acquired his interests in the partnerships “subject to” the debts, even though he did not personally assume those debts, which remained non-recourse with respect to the partners individually. Additionally, the court rejected the IRS’s contention that the son “[stood] in his father’s shoes and must treat the passed-through interest the same way his father did.” The court explained that neither Section 163(d) nor its implementing regulations include any family attribution rule or similar principle that would require this result.
The determination of whether interest expense of a partnership is to be characterized as investment interest or interest incurred in a trade or business is an important threshold question. Notably, under the interest expense limitation rules of Section 163(j), a section which was significantly amended in the 2017 Tax Cuts and Jobs Act, how partnerships and their partners are to characterize the corresponding interest expense if a partnership makes a debt-financed distribution is an issue that needs to be addressed through regulatory guidance.
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