Limited partner’s investment interest from trader partnership deductible above-the-line
Rev Rul 2008-38, 2008-31 IRB; Ann. 2008-65, 2008-31 IRB
Earlier this year, IRS issued Rev Rul 2008-12, 2008-10 IRB 520 concluding that where a non-corporate limited partner doesn’t materially participate in the partnership’s activity, his distributive share of the interest expense on debt allocable to the entity’s trade or business of trading securities is investment interest, subject to the Code Sec. 163(d)(1) deduction limitation. Because it received a number of queries as to where to report such interest, IRS has issued a new revenue ruling amplifying the earlier one and a new announcement clarifying where to report such interest.
Specifically, new Rev Rul 2008-38 provides that, in the case of an individual, interest paid or accrued on debt allocable to property held for investment described in Code Sec. 163(d)(5)(A)(ii) is (to the extent allowable after the application of the Code Sec. 163(d) limitation) a deduction described in Code Sec. 62(a)(1) and is therefore taken into account in determining the individual’s adjusted gross income (AGI). New Ann. 2008-65, 2008-31 IRB clarifies that the limited partner described in Rev Rul 2008-12 properly includes the allowable amount of his distributive share of the trading partnership’s interest expense in computing the limited partner’s ordinary business income or loss on Schedule E of the partner’s Form 1040.
Background. Deductions attributable to a trade or business carried on other than as an employee are deductible in arriving at AGI. (Code Sec. 62(a)(1))
The amount of investment interest that may be deducted in any tax year by a noncorporate taxpayer generally is limited to his net investment income for the year. (Code Sec. 163(d)(1)) Investment interest is any interest allowable as a deduction that is paid or accrued on debt properly allocable to property held for investment. (Code Sec. 163(d)(3)(A)) Property held for investment includes any interest held by a taxpayer in an activity involving the conduct of a trade or business that is not a passive activity and in which the taxpayer doesn’t materially participate (as those terms are used in the Code Sec. 469 passive activity loss rules). (Code Sec. 163(d)(5)(A)(ii))
A taxpayer’s activity includes an activity conducted through a partnership. (Reg. § 1.469-4(a)) An interest in an activity includes both an interest in property used in an activity and an interest in an activity held through a partnership. (Reg. § 1.469-2T(c)) Under Reg. § 1.469-1T(e)(6), an activity of trading personal property for the account of owners of interests in the activity isn’t a passive activity (without regard to whether the activity is a trade or business activity).
Under Code Sec. 702(b), the character of any item of income, gain, loss, deduction, or credit included in a partner’s distributive share is determined as if such item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership.
Facts in Situation 1 of new ruling. PRS is a partnership that is engaged solely in the trade or business of trading securities for its own account and not for customers. LP, an individual, owns an interest in PRS as a limited partner. He does not materially participate in the activity in which PRS is engaged. The tax year for PRS and LP is the calendar year. PRS incurs debt in its trade or business. In Year 1, LP’s distributive share of PRS’ tax items includes $200,000 of interest expense incurred by PRS on its debt. LP’s net investment income for Year 1 is $150,000. During Year 1, his distributive share of PRS’ interest expense is the only investment interest he paid or accrued. LP’ distributive share of PRS’ interest expense is not subject to any limitation under Code Sec. 465.
Result in Situation 1. LP may deduct $150,000 of his $200,000 distributive share of PRS’s interest expense. Under Code Sec. 163(d)(2), the $50,000 of interest expense not allowed as a deduction for Year 1 is treated as investment interest paid or accrued in Year 2. His distributive share of PRS’ Year 1 interest expense that is allowed under Code Sec. 163(d)(1) is deductible in arriving at his AGI under Code Sec. 62(a)(1). The investment interest limitation does not affect the character of LP’s interest expense for other purposes. Thus, except for purposes of applying the investment interest limitation, LP’s distributive share of PRS’ interest expense deductions are characterized under Code Sec. 702(b). Accordingly, $150,000 of LP’s distributive share of the Year 1 interest expense of PRS is deductible in arriving at LP’s adjusted gross income.
Situation 2 facts and result. The facts are the same as in Situation 1 except that during Year 1 LP also pays $100,000 of interest expense on debt properly allocable to stocks and bonds held by LP for investment (within the meaning of Code Sec. 163(d)(5)(A)(i)). Under Code Sec. 163(d)(1), LP is allowed to deduct only $150,000 of his $300,000 of investment interest expense in Year 1. To the extent that this amount is attributable to debt incurred in PRS’ trade or business, the deduction is taken into account in arriving at LP’s AGI; to the extent it is attributable to the debt allocable to the stock and bonds held for investment, the deduction is reported as an itemized deduction. When an individual, such as LP, has both investment interest expense attributable to property described in Code Sec. 163(d)(5)(A)(i) and investment interest expense attributable to property described in Code Sec. 163(d)(5)(A)(ii) and his aggregate investment interest expense is greater than his net investment income, he must allocate his net investment income to the two categories of investment interest expenses using a reasonable method of allocation. One reasonable method is to allocate the net investment income to the two categories of investment interest in the same proportion that the amount of investment interest in each category bears to the total amount of investment interest (the pro rata method). As shown in Rev Rul 2008-38 this method would allow LP to deduction $100,000 above-the-line and $50,000 below the line.