personal interest expense

When Does Interest Qualify as Business Interest?

Mar 14th 2019
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A qualified small business taxpayer can generally deduct business interest expenses in full, even under the latest rules. In a new case, Pugh TC Summary Opinion 2019-2, 2/28/19, the IRS claimed that a business interest deduction was a personal expense, but the taxpayer prevailed in court.

Generally, interest is characterized as falling into one of four baskets.

  • Mortgage interest on a loan secured by a qualified residence may be fully deductible. However, the Tax Cuts and Jobs Act (TCJA) limits the deduction to mortgage interest paid on the first $750,000 of new acquisition debt (down from $1 million).
  • Investment interest is deductible, but only up to the amount of “net investment income” for the year. This includes gross income from property held for investment such as interest, annuities and royalties. Any excess is carried over to the next year.
  • Business interest may be deductible in full as an ordinary and necessary business expense. Under the TCJA, the annual deduction is capped at 30 percent of adjusted gross income (AGI), but a qualified small business is exempt from this limit.
  • Personal interest—for example, interest paid on credit card debt—is completely nondeductible.

The taxpayer in the new case, a resident of Texas, operated a software development company as a self-employed individual. He also had a few employees and conducted all business from an office in his house.

In 2005 and 2006, the taxpayer purchased two vacant lots: one adjacent to land he already owned and the other directly across the street. He borrowed money to do so and paid interest on those loans during the tax years in question. Thereafter, he purchased two steel buildings, disassembled them and stored some of the components on one of the properties. His plan was to reassemble the buildings on the properties as the business headquarters.

However, before the taxpayer’s plan could be put into effect, the business lost a major customer, revenues plummeted and some employees left to work for other employers. As of the date of trial, the properties, some of which were sold, remained undeveloped, and some of the components of the steel buildings were sold as scrap metal.

Under the Tax Code Section 163(d), a taxpayer other than a corporation may deduct investment interest only to the extent of investment income. For this purpose,  “investment interest” is interest paid or accrued on debt properly allocable to property held for investment.” According to the IRS, the properties were never actually used in a trade or business, so they must be treated as being held for investment. Because the taxpayer has no investment income, the IRS denied any deduction.

Alternatively, the IRS argued that the interest paid on the properties is personal. Therefore, the taxpayer is still not entitled to a deduction.

But the Tax Court disagreed with the IRS’s reasoning. Under the prevailing regulations, interest paid or accrued on debt properly allocable to a trade or business is excluded from the general rule relating to investment interest. Although the properties weren’t actually used in the taxpayer’s trade or business during the tax years in question, the Court was satisfied the interest was allocable. Result: A taxpayer victory.

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