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amount payable under the contract may be re- characterized as interest (unstated interest). The amount recharacterized as interest reduces your basis in the property and increases your interest expense. For more information on in- stallment sales and unstated interest, see Pub. 537. Interest You Cannot Deduct Certain interest payments cannot be deducted. In addition, certain other expenses that may seem to be interest but are not cannot be de- ducted as interest. You cannot currently deduct interest that must be capitalized, and you generally cannot deduct personal interest. Interest paid with funds borrowed from original lender. If you use the cash method of accounting, you cannot deduct interest you pay with funds borrowed from the original lender through a second loan, an advance, or any other arrangement similar to a loan. You can deduct the interest expense once you start making payments on the new loan. When you make a payment on the new loan, you first apply the payment to interest and then to the principal. All amounts you apply to the in- terest on the first loan are deductible, along with any interest you pay on the second loan, sub- ject to any limits that apply. Capitalized interest. You cannot currently de- duct interest you are required to capitalize un- der the uniform capitalization rules. See Capi- talization of Interest, later. In addition, if you buy property and pay interest owed by the seller (for example, by assuming the debt and any interest accrued on the property), you cannot deduct the interest. Add this interest to the basis of the property. Commitment fees or standby charges. Fees you incur to have business funds available on a standby basis, but not for the actual use of the funds, are not deductible as interest payments. You may be able to deduct them as business expenses. If the funds are for inventory or certain prop- erty used in your business, the fees are indirect costs and you generally must capitalize them under the uniform capitalization rules. See Cap- italization of Interest, later. Interest on income tax. Interest charged on income tax assessed on your individual income tax return is not a business deduction even though the tax due is related to income from your trade or business. Treat this interest as a business deduction only in figuring an NOL de- duction. Penalties. Penalties on underpaid deficien- cies and underpaid estimated tax are not inter- est. You cannot deduct them. Generally, you cannot deduct any fines or penalties. Interest on loans with respect to life insur- ance policies. You generally cannot deduct interest on a debt incurred with respect to any life insurance, annuity, or endowment contract that covers any individual unless that individual is a key person. If the policy or contract covers a key person, you can deduct the interest on up to $50,000 of debt for that person. However, the deduction for any month cannot be more than the interest fig- ured using Moody's Composite Yield on Seas- oned Corporate Bonds (formerly known as Moody's Corporate Bond Yield Aver- age—Monthly Average Corporates) (Moody's rate) for that month. Who is a key person? A key person is an officer or 20% owner. However, the number of individuals you can treat as key persons is limi- ted to the greater of the following. • Five individuals. • The lesser of 5% of the total officers and employees of the company or 20 individu- als. Exceptions for pre-June 1997 contracts. You can generally deduct the interest if the con- tract was issued before June 9, 1997, and the covered individual is someone other than an employee, officer, or someone financially inter- ested in your business. If the contract was pur- chased before June 21, 1986, you can gener- ally deduct the interest no matter who is covered by the contract. Interest allocated to unborrowed policy cash value. Corporations and partnerships generally cannot deduct any interest expense allocable to unborrowed cash values of life in- surance, annuity, or endowment contracts. This rule applies to contracts issued after June 8, 1997, that cover someone other than an officer, director, employee, or 20% owner. For more in- formation, see section 264(f). Capitalization of Interest Under the uniform capitalization rules, you gen- erally must capitalize interest on debt equal to your expenditures to produce real property or certain tangible personal property. The property must be produced by you for use in your trade or business or for sale to customers. You can- not capitalize interest related to property that you acquire in any other manner. Interest you paid or incurred during the pro- duction period must be capitalized if the prop- erty produced is designated property. Designa- ted property is any of the following. • Real property. • Tangible personal property with a class life of 20 years or more. • Tangible personal property with an estima- ted production period of more than 2 years. • Tangible personal property with an estima- ted production period of more than 1 year if the estimated cost of production is more than $1 million. Property you produce. You produce property if you construct, build, install, manufacture, de- velop, improve, create, raise, or grow it. Treat property produced for you under a contract as produced by you up to the amount you pay or incur for the property. Carrying charges. Carrying charges include taxes you pay to carry or develop real estate or to carry, transport, or install personal property. You can choose to capitalize carrying charges not subject to the uniform capitalization rules if they are otherwise deductible. For more infor- mation, see chapter 7. Capitalized interest. Treat capitalized interest as a cost of the property produced. You recover your interest when you sell or use the property. If the property is inventory, recover capitalized interest through cost of goods sold. If the prop- erty is used in your trade or business, recover capitalized interest through an adjustment to basis, depreciation, amortization, or other method. Partnerships and S corporations. The inter- est capitalization rules are applied first at the partnership or S corporation level. The rules are then applied at the partners' or shareholders' level to the extent the partnership or S corpora- tion has insufficient debt to support the produc- tion or construction costs. If you are a partner or a shareholder, you may have to capitalize interest you incur during the tax year for the production costs of the part- nership or S corporation. You may also have to capitalize interest incurred by the partnership or S corporation for your own production costs. To properly capitalize interest under these rules, you must be given the required information in an attachment to the Schedule K-1 you receive from the partnership or S corporation. Additional information. The procedures for applying the uniform capitalization rules are be- yond the scope of this publication. For more in- formation, see sections 1.263A-8 through 1.263A-15 of the regulations and Notice 88-99. Notice 88-99 is in Cumulative Bulletin 1988-2. When To Deduct Interest If the uniform capitalization rules, discussed un- der Capitalization of Interest, earlier, and the business interest expense deduction limitation rules discussed under Interest Expense Limita- tion, earlier, do not apply, deduct interest as fol- lows. Cash method. Under the cash method, you can generally deduct only the interest you ac- tually paid during the tax year. You cannot de- duct a promissory note you gave as payment because it is a promise to pay and not an actual payment. Prepaid interest. You generally cannot de- duct any interest paid before the year it is due. Interest paid in advance can be deducted only in the tax year in which it is due. Discounted loan. If interest or a discount is subtracted from your loan proceeds, it is not a payment of interest and you cannot deduct it when you get the loan. For more information, see Original issue discount (OID) under Interest You Can Deduct, earlier. Refunds of interest. If you pay interest and then receive a refund in the same tax year of any part of the interest, reduce your interest Page 16 Chapter 4 Interest