Question: I received a distribution from a limited liability company in which I am an owner representing proceeds from the refinancing of a commercial loan on company property. Can I deduct my share of the interest on this debt?
Answer: The deductibility of interest on your share of limited liability company (“LLC”) debt depends upon how you utilize the refinancing proceeds which are distributed to you. If the proceeds are utilized for an expenditure or investment for which interest deductions are allowable, then you can deduct your share of the interest on the LLC debt. In all other cases, your share of the interest will not be deductible.
Interest expenses are only deductible in certain circumstances. Interest expense on debt proceeds used for a personal expenditure is not deductible. Interest deductions are also proscribed to the extent loan proceeds are used to purchase or maintain tax-exempt securities. Accordingly, if you utilize your share of the refinancing proceeds to buy a new car or take a vacation, your share of interest on the debt will not be deductible. Similarly, if you use the proceeds to purchase tax-exempt municipal bonds, your share of the interest on the LLC debt will not be deductible. While home mortgage interest is generally deductible, the debt must be secured by a mortgage on your residence which is not the case since your lender, not the LLC’s lender, would hold the mortgage on your home.
Any interest expense on debt proceeds utilized for investment purposes will be treated as investment interest and will be deductible subject to limitations. Investment interest expense is treated as an itemized deduction that can be deducted on your personal income tax returns. However, because of the relatively high thresholds for itemizing deductions, $24,000 for taxpayers filing joint income tax returns with their spouses and $12,000 for single filers, investment interest characterization will not provide any benefit to you unless your aggregate itemized deductions exceeds these thresholds.
A separate limitation on the deduction of investment interest will only permit such deductions to the extent of investment income. Any investment interest expense which cannot be deducted due to insufficient investment income can be carried forward to future years for potential deduction. Investment income generally consists of interest, dividends, short-term capital gains and similar sources of income. Investment income excludes long-term capital gains and dividends qualifying for the 15% or 20% Federal income tax rate, so-called “qualified dividends”, unless you elect to treat such long-term capital gains and qualified dividends as investment income. If you make this election, your long-term capital gains and qualified dividends will be subject to tax at ordinary income tax rates.
One question that arises is determining how to allocate the debt refinancing proceeds to the expenditures being made. IRS Treasury Regulations have established tracing rules to provide guidance for this purpose. If the proceeds you receive are all deposited in a bank or similar account, then your share of the interest on the LLC debt will be treated as investment interest to the extent of the funds deposited. For this purpose, funds deposited in a bank or similar account are deemed disbursed on a first-in, first-out basis, except that non-borrowed funds in an account are ignored. This means that if you deposit the debt proceeds in an existing account with funds of your own that you have not borrowed, the amounts disbursed from the account will first be deemed to consist of proceeds from the LLC debt refinancing and your use of those funds will determine whether or not your share of interest on the LLC debt can be deducted.
If you have sufficient itemized deductions and investment income, investment interest expense treatment would appear to be optimal. You should consider opening a new bank or similar account to hold the refinancing proceeds segregated from other funds. To the extent possible, you should make expenditures for which interest is not deductible from a different account. This will permit your refinancing proceeds to be deemed to be held for investment thereby giving you an opportunity to deduct your share of interest on the LLC debt.
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