Page 15

Celina 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 4 through December 31, she must treat $40,000 of the loan as used for personal purpo- ses, $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. Example. On January 9, Olena opened a checking account, depositing $500 of the pro- ceeds of Loan A and $1,000 of unborrowed funds. The following table shows the transac- tions in her account during the tax year. Date Transaction January 9 $500 proceeds of Loan A and $1,000 unborrowed funds deposited January 14 $500 proceeds of Loan B deposited February 19 $800 used for personal purposes February 27 $700 used for passive activity June 19 $1,000 proceeds of Loan C deposited November 20 $800 used for an investment December 18 $600 used for personal purposes Olena treats the $800 used for personal pur- poses 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, Olena 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 re- ceive loan proceeds in cash or if the loan pro- ceeds are deposited in an account, you can treat any payment (up to the amount of the pro- ceeds) 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 ac- count, 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 earlier 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. Example. Giovanni gets a loan of $1,000 on August 4 and receives the proceeds in cash. Giovanni deposits $1,500 in an account on Au- gust 18 and on August 28 writes a check on the account for a passive activity expense. Also, Giovanni deposits his paycheck, deposits other loan proceeds, and pays his bills during the same period. Regardless of these other trans- actions, Giovanni can treat $1,000 of the de- posit he made on August 18 as being paid on August 4 from the loan proceeds. In addition, Giovanni can treat the passive activity expense he paid on August 28 as made from the $1,000 loan proceeds treated as deposited in the ac- count. 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 account. However, you can use this optional method only if you treat all payments from the account dur- ing the same calendar month in the same way. Interest on a segregated account. If you have an account that contains only loan pro- ceeds and interest earned on the account, you can treat any payment from that account as be- ing made first from the interest. When the inter- est earned is used up, any remaining payments are from loan proceeds. Example. 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 pur- poses. 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 depos- ited in the account until the time of the with- drawal is investment interest expense. The in- terest 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 reallo- cate it to another use is personal interest ex- pense. The interest charged on the loan pro- ceeds you left in the account ($867) continues to be investment interest expense until you ei- ther repay it or reallocate it to another use. Loan repayment. When you repay any part of a loan allocated to more than one use, treat it as being repaid in the following order. 1. Personal use. 2. Investments and passive activities (other than those included in (3)). 3. Passive activities in connection with a rental real estate activity in which you ac- tively participate. 4. Former passive activities. 5. Trade or business use and expenses for certain low-income housing projects. Line of credit (continuous borrowings). The following rules apply if you have a line of credit or similar arrangement. 1. Treat all borrowed funds on which interest accrues at the same fixed or variable rate as a single loan. 2. Treat borrowed funds or parts of borrowed funds on which interest accrues at differ- ent fixed or variable rates as different loans. Treat these loans as repaid in the order shown on the loan agreement. Loan refinancing. 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. Debt-financed distribution. A debt-financed distribution occurs when a partnership or S cor- poration borrows funds and allocates those funds to distributions made to partners or shareholders. The manner in which you report the interest expense associated with the distrib- uted debt proceeds depends on your use of those proceeds. How to report. If the proceeds were used in a nonpassive trade or business activity, re- port the interest on Schedule E (Form 1040), line 28; enter “interest expense” and the name of the partnership or S corporation in column (a) and the amount in column (h). If the proceeds were used in a passive activity, follow the In- structions for Form 8582 to determine the amount of interest expense that can be repor- ted on Schedule E (Form 1040), line 28; enter “interest expense” and the name of the partner- ship in column (a) and the amount in column (f). If the proceeds were used in an investment ac- tivity, enter the interest on Form 4952. If the pro- ceeds are used for personal purposes, the in- terest is generally not deductible. Interest Expense Limitation You generally must limit business interest ex- pense you pay or accrue during the tax year, unless an exception to the limitation is met. The business interest expense deduction al- lowed for a taxable year is generally limited to the sum of: 1. Business interest income, 2. 30% of the adjustable taxable income, and 3. Floor plan financing interest. If the section 163(j) limitation applies, gener- ally the amount of any business interest ex- pense that is not allowed as a deduction under section 163(j) for the tax year is carried forward to the following year as a disallowed business Page 14 Chapter 4 Interest