Attorney-at-Law

MORTGAGED OUT

In Uncategorized on 08/28/2019 at 15:56

The move used to be that a real estate operator would increase the rent roll so that he (it was usually “he” in those days) could get a mortgage and let the renters pay it off, while he took the proceeds and bought other investments. The interest was deductible, and amortization was sheltered by depreciation. Of course the investment interest rules and the passive activity rules put paid to that maneuver, but fortune favors the wise.

William C. Lipnick and Dale A. Lipnick, 153 T. C. 1, filed 8/28/19, shows how Wm’s Dad Maurice, a real estate whiz, worked the deal, so Wm doesn’t have the Section 163(d) investment interest cap.

Maurice and his partner owned LLC memberships, and borrowed against their memberships and the assets of the LLCs (real estate, primarily). They distributed the loan proceeds to themselves in a debt-financed distribution. Maurice used the cash to buy investments. For the first couple years (hi, Judge Holmes) Maurice got the passthrough income and interest deduction from the LLCs, the latter subject to the Section 163(d) limitation.

Then Maurice gifts 50% of his ownership interests to Wm, and Wm signs on to what Judge Albert G (“Scholar Al”) Lauber calls “each partnership’s operating agreement.” 153 T. C. 1, at p. 5. Judge, though an LLC may be taxed as a partnership, it isn’t a partnership, it’s the child of a different statute.

But Wm didn’t assume the debts of the LLCs, didn’t use any proceeds to buy investments, and Maurice was relieved of said debt. Maurice treated the relief as taxable capital gain.

Maurice picked up some more debt-financed distributions, paid tax with the investment interest limitation, and died. Wm got more interests in the LLCs under his dad’s will.

Wm claimed the interest the LLCs paid wasn’t investment interest as to him, as he wasn’t liable on the debts and hadn’t used any of the proceeds to acquire any investments.

IRS claims Wm should have been subject to the investment interest limitations, hits him with Section 6662 chops, and a SNOD at no extra charge.

“Investment interest is defined as interest that is ‘paid or accrued on indebtedness properly allocable to property held for investment.’ Sec. 163(d)(3)(A).  The interest in question was incurred by [LLCs], which owned, operated, and actively managed apartment buildings and other rental real estate.  The loans on which the interest was paid were secured by those real estate assets.  Respondent does not contend that the operating assets held by the partnerships constituted ‘property held for investment.’” 153 T. C. 1, at p. 12. Of course not; the property was used in the trade or business of renting residential property.

The basic idea is that use of loan proceeds dictates character of interest. Borrow to go on vacation, personal interest. Borrow to buy investment property, investment interest plus passive activity rules. Borrow to run business, business debt.

Judge Scholar Al cut to the cliché. “In short, if a taxpayer uses debt proceeds to acquire an investment, the interest on that debt is investment interest regardless of whether the debt originated in a partnership.” 153 T. C. 1, at p. 14.

IRS claims “like father, like son.” If the loan proceeds were used to buy investments (and they were), then any interest paid on said loans, the incidents of which are passed through to the son, is investment interest.

Judge Scholar Al isn’t having it.

“We find no support for this theory in the statute, the regulations, or the decided cases.” 153 T. C. 1, at p. 14.

“William did not receive, directly or indirectly, any portion of the debt financed distributions that the partnerships made to Maurice….Nor did William use distributions from those partnerships to make ‘investment expenditure[s].’  See sec. 1.163-8T(a)(4)(i)(C), Temporary Income Tax Regs., supra.  In short, the facts that caused the passed-through interest to be ‘investment interest’ in Maurice’s hands simply do not apply to William.” 153 T. C. 1, at p. 15.

“Notice 89-35 refers to this scenario as a debt-financed acquisition, as opposed to a debt-financed distribution, and it explains how the regulation applies to partnerships and their partners:  ‘In the case of debt proceeds allocated under section 1.163-8T to the purchase of an interest in a passthrough entity (other than by way of a contribution to the capital of the entity), the debt proceeds and the associated interest expense shall be allocated among all the assets of the entity using any reasonable method.’

“In short, whereas Maurice received a debt-financed distribution, William is treated as having made a debt-financed acquisition of the partnership interests he acquired from Maurice.  See ibid.  For section 163(d) purposes, therefore, the debt proceeds are allocated among all of the partnerships’ real estate assets using a reasonable method, and the interest paid on the debt is allocated to those assets in the same way.  Sec. 1.163-8T(c)(1), Temporary Income Tax Regs., supra.” 153 T. C. 1, at p. 16.

And everyone agrees the real estate owned by the LLCs wasn’t investments, but property used in a trade or business.

And Wm never borrowed anything or bought any investments with the proceeds.

“Respondent urges us to adopt a ‘once investment interest, always investment interest’ rule on the theory that any other approach would ‘place a myriad of additional administrative burdens on both taxpayers and the government.’  But the temporary regulations and IRS guidance clearly dictate different outcomes depending on whether the partner receives a debt-financed distribution or makes a debt-financed acquisition.  See sec. 1.163-8T(c)(3)(ii), Temporary Income Tax Regs., supra; Notice 89-35, supra.  Recognition that partnership interests may change hands is thus an inherent part of the regulatory structure.  And the allocation is no more cumbersome than allocating debt for any other purpose under subchapter K.” 153 T. C. 1, at pp. 20-21.

Wm wins.

And a Taishoff “Good Job” goes to M. I. Sanders and J. E. Misener; though they may be at Blank Rome, they weren’t shooting blanks.

 

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  1. […] of course, Lew Taishoff is not going to let a regular Tax Court decision pass him by.  He has Mortgaged Out evoking an old real estate […]

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  2. […] of course, Lew Taishoff is not going to let a regular Tax Court decision pass him by.  He has Mortgaged Out evoking an old real estate […]

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  3. […] of course, Lew Taishoff is not going to let a regular Tax Court decision pass him by.  He has Mortgaged Out evoking an old real estate […]

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