TD 8145 07 02 1987 Interest Tracing Regulations 1 163 8T AGENCY Internal Revenue Service Treasury ACTION Temporary regulations SUMMARY This document contains temporary regulations relating to the allocation of interest expense among a taxpayer s expenditures Changes to the applicable tax law were made by the Tax Reform Act of 1986 the Act The temporary regulations affect taxpayers subject to the passive loss limitation the investment interest limitation or the disallowance of deductions for personal interest and provide them with the guidance needed to comply with the law The text of the temporary regulations set forth in this document also serves as the text of the proposed regulations for the notice of proposed rulemaking on this subject in the Proposed Rules section of this issue of the Federal Register EFFECTIVE DATE The temporary regulations are effective with respect to interest expense paid or accrued in taxable years beginning after December 31 1986 FOR FURTHER INFORMATION CONTACT Michael J Grace of the Legislation and Regulations Division Office of Chief Counsel Internal Revenue Service 1111 Constitution Avenue NW Washington DC 20224 Attention CC LR T 202 566 3288 not a toll free call SUPPLEMENTARY INFORMATION Background This document amends the Income Tax Regulations 26 CFR Part 1 to provide temporary rules relating to the allocation of interest expense for purposes of applying the limitations on passive activity losses and credits investment interest and personal interest The temporary regulations reflect the amendment of the Internal Revenue Code of 1986 the Code by sections 501 and 511 of the Act 100 Stat 2233 and 2244 which added sections 469 relating to the limitation on passive activity losses and credits and 163 h relating to the disallowance of deductions for personal interest and amended section 163 d relating to the limitation on investment interest Section 469 provides that deductions from passive activities generally may not offset income other than passive income Section 163 d 1 limits the investment interest deduction of a noncorporate taxpayer for any taxable year to the taxpayer s net investment income for the taxable year Section 163 h 1 disallows deductions for personal interest paid or accrued by a noncorporate taxpayer Qualified residence interest described in section 163 h 3 does not constitute personal interest Section 469 e 1 A i III provides that in determining the income or loss from any passive activity there shall not be taken into account interest expense properly allocable to certain items of gross income including gross income from interest dividends annuities or royalties not derived in the ordinary course of a trade or business Section 469 k 4 provides that the Secretary of the Treasury shall prescribe such regulations as may be necessary or appropriate to carry out the provisions of section 469 including regulations which provide for the determination of the allocation of interest expense for purposes of section 469 The Joint Explanatory Statement of the Committee of Conference accompanying the Act the Conference Report states that the conferees anticipate the Treasury will issue regulations providing guidance to taxpayers with respect to interest allocation The Conference Report further provides that these regulations should be consistent with the purpose of the passive loss rules to prevent sheltering of 1 income from personal services and portfolio investments with passive losses and that the regulations should attempt to avoid inconsistent allocations of interest deductions under different Code provisions Although regulations allocating interest expense are specifically authorized by section 469 k 4 these regulations are being published under section 163 because it is believed most taxpayers seeking guidance concerning the tax treatment of interest expense will first consult the regulations under section 163 Scope of Rules These temporary regulations prescribe rules for allocating interest expense for purposes of applying the passive loss limitation and the limitations on investment interest and personal interest Except as otherwise specifically provided these rules do not control the allocation of interest for other purposes e g the windfall profit tax Other limitations on the deductibility of interest expense generally apply without regard to the manner in which interest expense is allocated under the temporary regulations Thus for example section 265 a 2 may disallow deductions for interest expense allocated under the temporary regulations to an expenditure in connection with a trade or business producing taxable income Similarly section 263A f may require the capitalization of interest allocated under the temporary regulations to a noncapital expenditure The temporary regulations provide however that interest expense allocated to a personal expenditure cannot be capitalized Interest expense may also be deferred to a later year by one of the other limitations on the deductibility of interest by the operation for example of section 267 a 2 In that case the interest expense is allocated to expenditures under the temporary regulations as it would have been had the deferral provision not applied but is not taken into account for purposes of applying the passive loss investment interest and personal interest limitations until the taxable year in which the deferral provision ceases to apply Qualified residence interest is deductible without regard to the manner in which such interest is allocated under these rules Allocation Rules in General Interest expense on a debt is allocated in the same manner as the debt to which the interest relates is allocated Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures Thus the allocation of interest is not affected by the use of an interest in any property to secure repayment of the debt to which the interest relates The regulations provide specific rules for determining the manner in which debt is allocated if the debt proceeds are deposited to the borrower s account Rules are also provided for cases in which debt proceeds are not disbursed to the borrower as in the case of seller financing or in which the borrower receives debt proceeds in cash Interest expense generally is subject to the limitation applicable to the expenditure to which the underlying debt is allocated Thus for example if debt proceeds are allocated to an expenditure in connection with a