Interest expense is a part of life for nearly everyone. Unless you're a die hard Dave Ramsey (no hate here) 👴🏻, you likely pay interest expense on your mortgage 🏡, credit cards 💳, and auto loans 🚗. And it's no less prevalent in business.

Prior to 1986, all interest expense paid was generally deductible by everyone - people and businesses. Which, if you've ever looked at an interest rate chart for the 1980s, you'd see why this became a serious revenue raising opportunity for the IRS 👇

Cue the Interest Tracing Rules that were included in the massive overhaul of the tax code in 1986. 💣 Today we're going to run through a couple of points on how those changes impact us today:

• Why Interest Expense is targeted? 🤷🏻‍♂️
• Interest Tracing rules in general 🏃🏻
• Two ways it impacts SMB tax ✌️

Let's dig in.

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Why Interest Expense gets targeted?

From a tax perspective, interest expense is unique. It's an ongoing finance charge that, at least until 1986, was treated differently than the underlying purpose for the interest expense.

An example - if I want to buy a boat (I don't) ⛵ to use on family vacations, I cannot deduct the cost of that boat. But under the pre-1986 rules, the interest expense I'd be paying to "own" the boat would be deductible - effectively side-stepping the non-deductibility of the personal use asset.

It then can get pretty slippery 🧼 to do creative tax planning - selling a $10,000 boat (no idea what they cost - sorry boat people) for $1 but interest payments totaling $9,999. This is an extreme example, but it proves the point of the unique opportunity interest represents and why Congress cares so much about how it's used.

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Interest Tracing Rules in general

Interest tracing rules came into play to limit another type of abuse that was happening. Taxpayers were taking out loans on appreciated property 🏦, using those loan proceeds to buy other non-related assets 🏎️, and fully deducting the interest that was related to the loans on the unappreciated property.

Another example - I own an apartment building that has substantially appreciated (I don't). I want to use "tax-free" loans to pay for my boat instead of taking out a personal loan for it. Since I can't deduct the interest on my personal tax return, I'll be able to deduct the interest on the business return for the apartment complex, right? Nope.

Interest tracing requires the borrower to "follow the use of the loan proceeds" to determine the character of the deduction - versus using the collateral of the borrowing to determine if it can be deducted. 🔍

In our apartment example, the distribution I took out from the refinance would require special reporting on the subsequent interest expense the business would pay on that refinance (I'll get into this more below) - requiring me to acknowledge that I used those proceeds for personal consumption and therefore the interest is not deductible. 😧

In general, this tracing of interest expense can convert it's character from a business expense to:

• Investment interest expense (if used to buy investments) 📈
• Additional business interest expense (if used in another business) 🗂️
• Home mortgage interest expense (if used to pay off my mortgage) 🏠
• Nondeductible interest expense (if used to buy that boat after all) 🚤

It's worth noting that documentation is key here. Keep good records of what loan proceeds taken out against appreciated assets are for - especially when it's going from a normally deductible expense (business) to questionable use (personal-ish).

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How Interest Rules Hit SMB

Two ways I want to cover for how small business taxpayers get impacted here:

1. Debt-financed Distributions
2. 163j Limitation

Okay, so the first one is more of a real estate impact but it can still happen in small business. This is what was alluded to above in the apartment example. When distributions are made to partners that were financed with new debt, a calculation must be done and the amount of interest expense related to the distributed debt is reported separately (another Box 13 slush amount 🥤). The recipient partner (or his unwitting CPA 👨‍💼) then works to determine whether that interest is deductible based on what the distribution was used for.

In reality, I'd estimate 75% of K1s are missing this disclosure that I've seen. And on the ones we send out that have this, I'd estimate 90% of CPAs don't ask the question. It's tricky, but those are the rules. 😭

Second, and 10x worse than Debt-financed distributions, is the new 163j limitation rules that hit in 2017. In short, this was a way that Congress helped pay for some of the 2017 tax cuts. This law limits the amount of interest a business can deduct to 30% of pre-interest income (the calculation is more complicated, but let's not do that now). 🫨

But that 30% limitation didn't kick in until revenue crossed $30MM (technically gross receipts on an average 3 years, but again, stay with me). As such, many small businesses ignored and are still ignoring it. But there was a catch. 🎣

If your business is running a loss and is allocating 35% or more of that loss to "passive investors" then your business is a "tax shelter" and is now subject to this limitation regardless of revenue size. 🤯 This crushes real estate that runs losses, has a high amount of "passive investors" and is usually leveraged up.

It's worth noting that there is an election for rental real estate to deduct interest still with some trade-offs. ⚖️ But I can't tell you how many times I still see this missed and / or done wrong.

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Okay, let's land the plane. 🛬 Interest expense is a unique deduction for taxpayers and businesses. It requires careful tracking and documentation to support the deduction. And for small business and real estate groups it be especially tricky to continue to be able to deduct the interest paid entirely.

Remember to always consult with a professional - I'm no attorney and every situation is unique.

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