The rules for deducting interest vary, depending on whether the
loan proceeds are used for business, personal, investment, or passive
activities. If you use the proceeds of a loan for more than one type
of expense, you must make an allocation to determine the interest for
each use of the loan's proceeds.
Allocate your interest expense to the following categories.
- Trade or business interest
- Passive activity interest
- Investment interest
- Portfolio interest
- Personal interest
In general, you allocate interest on a loan the same way you
allocate the loan proceeds. You allocate loan proceeds by tracing
disbursements to specific uses.
The easiest way to trace disbursements to specific uses is to keep
the proceeds of a particular loan separate from any other funds.
The allocation of loan proceeds and the related interest is not
generally affected by the use of property that secures the loan.
You secure a loan with property used in your business. You use the
loan proceeds to buy an automobile for personal use. You must allocate
interest expense on the loan to personal use (purchase of the
automobile) even though the loan is secured by business property.
If the property that secures the loan is your home, you generally
do not allocate the loan proceeds or the related interest. The
interest is usually deductible as qualified home mortgage interest,
regardless of how the loan proceeds are used. For more information,
see Publication 936.
The period for which a loan is allocated to a particular use begins
on the date the proceeds are used and ends on the earlier of the
- The date the loan is repaid.
- The date the loan is reallocated to another use.
Proceeds not disbursed to borrower.
Even if the lender disburses the loan proceeds to a third party,
the allocation of the loan is still based on your use of the funds.
This applies whether you pay for property, services, or anything else
by incurring a loan, or you take property subject to a debt.
Proceeds deposited in borrower's account.
Treat loan proceeds deposited in an account as property held for
investment. It does not matter whether the account pays interest. Any
interest you pay on the loan is investment interest expense. If you
withdraw the proceeds of the loan, you must reallocate the loan based
on the use of the funds.
Connie, a calendar-year taxpayer, borrows $100,000 on January 4 and
immediately uses the proceeds to open a checking account. No other
amounts are deposited in the account during the year and no part of
the loan principal is repaid during the year. On April 1, Connie uses
$20,000 from the checking account for a passive activity expenditure.
On September 1, Connie uses an additional $40,000 from the account for
Under the interest allocation rules, the entire $100,000 loan is
treated as property held for investment for the period from January 4
through March 31. From April 1 through August 31, Connie must treat
$20,000 of the loan as used in the passive activity and $80,000 of the
loan as property held for investment. From September 1 through
December 31, she must treat $40,000 of the loan as used for personal
purposes, $20,000 as used in the passive activity, and $40,000 as
property held for investment.
Order of funds spent.
Generally, you treat loan proceeds deposited in an account as used
(spent) before either of the following amounts.
- Any unborrowed amounts held in the same account.
- Any amounts deposited after these loan proceeds.
On January 9, Edith opened a checking account, depositing $500 of
the proceeds of Loan A and $1,000 of unborrowed funds. The following
table shows the transactions in her account during the tax year.
||$500 proceeds of Loan A and
$1,000 unborrowed funds
||$500 proceeds of Loan B
||$800 used for personal
||$700 used for passive
||$1,000 proceeds of Loan C
||$800 used for an
||$600 used for personal
Edith treats the $800 used for personal purposes as made from the
$500 proceeds of Loan A and $300 of the proceeds of Loan B. She treats
the $700 used for a passive activity as made from the remaining $200
proceeds of Loan B and $500 of unborrowed funds. She treats the $800
used for an investment as made entirely from the proceeds of Loan C.
She treats the $600 used for personal purposes as made from the
remaining $200 proceeds of Loan C and $400 of unborrowed funds.
For the periods during which loan proceeds are held in the account,
Edith treats them as property held for investment.
Payments from checking accounts.
Generally, you treat a payment from a checking or similar account
as made at the time the check is written if you mail or deliver it to
the payee within a reasonable period after you write it. You can treat
checks written on the same day as written in any order.
Amounts paid within 30 days.
If you receive loan proceeds in cash or if the loan proceeds are
deposited in an account, you can treat any payment (up to the amount
of the proceeds) made from any account you own, or from cash, as made
from those proceeds. This applies to any payment made within 30
days before or after the proceeds are received in cash or
deposited in your account.
If the loan proceeds are deposited in an account, you can apply
this rule even if the rules stated earlier under Order of funds
spent would otherwise require you to treat the proceeds as used
for other purposes. If you apply this rule to any payments, disregard
those payments (and the proceeds from which they are made) when
applying the rules stated under Order of funds spent.
If you received the loan proceeds in cash, you can treat the
payment as made on the date you received the cash instead of the date
you actually made the payment.
Frank gets a loan of $1,000 on August 4 and receives the proceeds
in cash. Frank deposits $1,500 in an account on August 18 and on
August 28 writes a check on the account for a passive activity
expense. Also, Frank deposits his paycheck, deposits other loan
proceeds, and pays his bills during the same period. Regardless of
these other transactions, Frank can treat $1,000 of the deposit he
made on August 18 as being paid on August 4 from the loan proceeds. In
addition, Frank can treat the passive activity expense he paid on
August 28 as made from the $1,000 loan proceeds treated as deposited
in the account.
Optional method for determining date of reallocation.
You can use the following method to determine the date loan
proceeds are reallocated to another use. You can treat all payments
from loan proceeds in the account during any month as taking place on
the later of the following dates.
- The first day of that month.
- The date the loan proceeds are deposited in the
However, you can use this optional method only if you treat all
payments from the account during the same calendar month in the same
Interest on a separate account.
If you have an account that contains only loan proceeds and
interest earned on the account, you can treat any payment from that
account as being made first from the interest. When the interest
earned is used up, any remaining payments are from loan proceeds.
You borrowed $20,000 and used the proceeds of this loan to open a
new savings account. When the account had earned interest of $867, you
withdrew $20,000 for personal purposes. You can treat the withdrawal
as coming first from the interest earned on the account, $867, and
then from the loan proceeds, $19,133 ($20,000 - $867). All the
interest charged on the loan from the time it was deposited in the
account until the time of the withdrawal is investment interest
expense. The interest charged on the part of the proceeds used for
personal purposes ($19,133) from the time you withdrew it until you
either repay it or reallocate it to another use is personal interest
expense. The interest charged on the loan proceeds you left in the
account ($867) continues to be investment interest expense until you
either repay it or reallocate it to another use.
When you repay any part of a loan allocated to more than one use,
treat it as being repaid in the following order.
- Personal use.
- Investments and passive activities (other than those
included in (3)).
- Passive activities in connection with a rental real estate
activity in which you actively participate.
- Former passive activities.
- Trade or business use and expenses for certain low-income
Line of credit (continuous borrowings).
The following rules apply if you have a line of credit or similar
- Treat all borrowed funds on which interest accrues at the
same fixed or variable rate as a single loan.
- Treat borrowed funds or parts of borrowed funds on which
interest accrues at different fixed or variable rates as different
loans. Treat these loans as repaid in the order shown on the loan
Allocate the replacement loan to the same uses to which the repaid
loan was allocated. Make the allocation only to the extent you use the
proceeds of the new loan to repay any part of the original loan.
and S Corporations
The following rules apply to the allocation of interest expense in
connection with debt-financed acquisitions of interests in
partnerships and S corporations. These rules also apply to the
allocation of interest expense in connection with debt-financed
distributions from partnerships and S corporations.
These rules do not apply if the partnership or S corporation is
formed or used for the principal purpose of avoiding the interest
A debt-financed acquisition is the use of loan proceeds to buy an
interest in, or to make a contribution to the capital of, a
partnership or S corporation.
You must allocate the loan proceeds and the related interest
expense among all the assets of the entity. You can use any reasonable
method. If you buy an interest in a partnership or S corporation
(other than by way of a contribution to capital), reasonable methods
include a pro rata allocation based on the fair market value, book
value, or adjusted basis of the assets, reduced by any debts allocated
to the assets.
If you contribute to the capital of a partnership or S corporation,
reasonable methods ordinarily include allocating the debt among all
the assets or tracing the loan proceeds to the entity's expenditures.
Treat the purchase of an interest in a partnership or S corporation
as a contribution to capital to the extent the entity receives any
proceeds of the purchase.
You buy an interest in a partnership for $20,000 using borrowed
funds. The partnership's only assets include machinery used in its
business valued at $60,000 and stocks valued at $15,000. You allocate
the loan proceeds based on the value of the assets. Therefore, you
allocate $16,000 of the loan proceeds ($60,000/$75,000 ×
$20,000) and the interest expense on that part to trade or business
use. You allocate the remaining $4,000 ($15,000/$75,000 ×
$20,000) and the interest on that part to investment use.
If you allocate the loan proceeds among the assets, you must make a
reallocation if the assets or the use of the assets change.
How to report.
Individuals should report their share of deductible partnership or
S corporation interest expense on either Schedule A or Schedule E of
Form 1040, depending on the type of asset (or expenditure if the
allocation is based on the tracing of loan proceeds) to which the
interest expense is allocated.
For interest allocated to trade or business assets (or
expenditures), report the interest in Part II, Schedule E (Form 1040).
On a separate line, put "business interest" and the name of the
partnership or S corporation in column (a) and the amount in column
For interest allocated to passive activity use, enter the interest
on Form 8582
as a deduction from the passive
activity of the partnership or S corporation. Show any deductible
amount in Part II, Schedule E (Form 1040). On a separate line, put
"passive interest" and the name of the entity in column (a) and
the amount in column (g).
For interest allocated to investment use, enter the interest on
Carry any deductible amount
allocated to royalties to Part II, Schedule E (Form 1040). On a
separate line enter "investment interest" and the name of the
partnership or S corporation in column (a) and the amount in column
(i). Carry the balance of the deductible amount to line 13, Schedule A
Any interest allocated to proceeds used for personal purposes is
generally not deductible.
A debt-financed distribution occurs when a partnership or S
corporation borrows funds and allocates those funds to distributions
made to partners or shareholders. The distributed loan proceeds and
related interest expense must be reported to the partners or
shareholders separately. This is because the loan proceeds and the
interest expense must be allocated depending on how the partner or
shareholder uses the proceeds.
This treatment of debt-financed distributions follows the general
allocation rules discussed earlier. For example, if a shareholder uses
distributed loan proceeds to invest in a passive activity, that
shareholder's portion of the S corporation's interest expense on the
loan proceeds is allocated to a passive activity use.
Optional allocation method.
The partnership or S corporation can choose to allocate the
distributed loan proceeds to other expenditures it makes during the
tax year of the distribution. This allocation is limited to the
difference between the other expenditures and any loan proceeds
already allocated to them. For any distributed loan proceeds that are
more than the amount allocated to the other expenditures, the rules in
the previous paragraph apply.
How to report.
If the entity does not use the optional allocation method, it
reports the interest expense on the loan proceeds on the line on
Schedule K-1 (Form 1065 or Form 1120S) for "Other deductions."
The expense is identified on an attached schedule as "Interest
expense allocated to debt-financed distributions." The partner or
shareholder claims the interest expense depending on how the
distribution was used.
If the entity uses the optional allocation method, it reports the
interest expense on the loan proceeds allocated to other expenditures
on the appropriate line or lines of Schedule K-1. For example,
if the entity chooses to allocate the loan proceeds and related
interest to a rental activity expenditure, the entity takes the
interest into account in figuring the net rental income or loss
reported on Schedule K-1.
For more information on allocating and reporting these interest
expenses, see Notice 88-37 in Cumulative Bulletin 1988-1.
Also see Notice 89-35 in Cumulative Bulletin 1989-1.
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