Chapter 10              p.583
Interest, Taxes & Losses              

Interest expense is deductible, subject to various limitations.  §163(a). 

What is “interest”?  Rent for the use of money.

Why provide a deduction for interest expense?

Business expense (cf., §162).

Investment expense (cf., §212).

Personal interest expense (cf., §262).

This treatment is subject to various exceptions, e.g., capitalization requirements.

Limitations on Interest Expense Deductions

Limitation examples: 

1) Limit on investment interest - §163(d).

2) Obligations not in registered form - §163(f).

3) Personal interest is not deductible, except for

home mortgage and home equity debt. §163(h).

4) Disqualified interest & foreign lender.§163(j).

5) Corporate debt-equity classification issues. §385 – note: October 2016 finalized regulations.

6) §265(a)(2) re interest to carry tax-exempts.

Defining “Interest”   p.584       
Knetch case

Permit deductions for this “interest expense”? 

Knetch bought deferred annuity bonds for $4 million, paying with $4,000 check and $4 million promissory note.  Debt was secured by bonds.  Prepaid 1st year’s interest of $140,000 and borrowed back $99,000 and then prepaid $3,465 interest on this 99k borrowing. This procedure was repeated in the subsequent year.

In fourth year this arrangement terminated and net equity of $1,000 received from the contract.

continued

Knetsch case, cont.

Trial court declares this transaction a “sham.”

Sup. Ct. analysis:  taxpayer paid a fee of $91,570 to produce this loan arrangement attempting to facilitate a $294,540 interest expense deduction - which enabled a tax reduction of $233,298 (assuming an 80 percent FIT rate).

Post-transaction tax provision (§264) limits this arrangement. But, no enactment date protection here – since here a non-existent deal.

Held: a sham transaction & no interest expense deduction permitted. Note: Douglas dissent. Cont.

Knetsch case, cont.

Is the Knetsch situation ultimately a losing proposition?

Depends upon (e.g.,):

Whether tax rate is less in the close-out year

(i.e., statutory tax rate changes or reduced income for this taxpayer);

Capital gains treatment (& significant tax

rate differential, e.g., 70% vs. 25%) at time close-out of deal; and,

3)  Investment benefits from deferral proceeds.

Goldstein & “Economic Substance” Rule       p.589

Taxpayer won $140,000 in Sweepstakes and (1) borrowed funds and (2) prepaid interest expense (to partially offset some of winnings).  Loan proceeds were used to buy U.S. Treasury obligations to provide interest income in a later year.  Current economic loss was incurred but expected tax savings:  reduced current income tax and pushing certain earnings forward.

Holding:  No §163 interest expense deduction since no non-tax purpose for the borrowing.

“Sham” vs. No Economic Substance

Should the transaction be treated as even occurring for non-tax purposes (i.e., it is not a “sham”),  but still not be recognized for federal income tax purposes (i.e., Goldstein case)?

See Code §7701(o)(1):  economic substance occurs only if:   (1) required meaningful change in the taxpayer’s economic position occurs, and (2) taxpayer has a “substantial purpose” apart from federal income tax effects for entering into the transaction.

Question 1, p. 594

What is the tax advisor’s responsibility in advising clients in this context?

Are professional risks existent?

See Problem 1(d) re fake documents.

Question 3, p. 594
Borrow & Life Insurance

Remember:  §101 excludes the life insurance policy internal build-up from GI inclusion.

Borrow to pay for the policy premiums?

See §264(a)(3) & (d) disallowing an interest expense deduction for borrowings to fund life insurance (which produces tax-free income).

But, see §264(d) concerning (1) paying four of the first seven premium payments and (2) then no limit applies to interest expense deduction.

Question 4b, p. 595
Interest paid by Tenant

B rents house and pays rent to landlord. 

The landlord uses a significant portion of the funds to pay mortgage debt (both P&I).

Can tenant deduct any of this interest expense?

What if tenant agrees to liability for the mortgage?   No -  not the tenant’s debt.

See Code §216 re deduction to “tenants” when amounts paid to a coop association (what is a co-op for this purpose;  cf., condo association).

Question 4c, p. 595
Interest paid by Child

Daughter pays mortgage amount for parents (& mortgage amount includes both P&I):

No interest expense deduction to the child;

but, a deduction to the parents for constructive payment by them of the interest expense?

b)  Daughter becomes jointly liable on the mortgage debt – then interest expense deduction to daughter – if the debt is genuine.

Question 4d, p. 595
Interest paid to Child

Parent executes a promissory note to child (e.g., for $10,000;  for gift?) and then pays interest expense (e.g., 7% or $7,000 per year) to child.

Questions re availability of deduction:

1)  Is the debt genuine, i.e., does it really exist?

2)  Is the payment really for interest expense?

3)  If really interest expense, is it tax deductible by the parent?  What is the real purpose for incurring this “debt”?

§265(a)(2)
p. 595   

No deduction is allowed for interest expense on debt “incurred or continued to purchase or carry obligations the interest on which is wholly exempt from the taxes imposed by this subtitle.”

I.e., §103 tax-exempt bonds.

What is the objective of this limitation?  To preclude “whipsawing the tax system.”

Remembering the Haverly case!

But, when does this debt exist which causes the actual denial of the interest expense deduction?

Rev. Proc. 72-18
p. 595   

Purpose to carry tax-exempts exists where borrowing is incurred to buy the tax-exempts.

Also, where the tax exempts are used as collateral for borrowing.

But, not where holding tax-exempts and temporarily borrowing in business when a cash deficit exists (i.e., a “business needs” exception).  Cf., Wis. Cheeseman case.

continued

Rev. Proc. 72-18
Individuals              p. 595             

The §265(a)(2) limitation is not applicable to an individual who (1) owns tax-exempts and (2) incurs home mortgage debt (the interest on the home mortgage debt is deductible).

Cf., an individual holding portfolio investments (e.g., stocks) & buying tax-exempts on margin (i.e., with stocks as partial collateral for the margin debt)? Is interest otherwise deductible?  Yes, except for §163(d) – see Yeager case.

Estate of Yaeger v. Commr.                  P.600   

“Investment interest” - §163(d) limits interest expense deduction to investment income (& not deductible against other business & personal income).  But, a §163(d) carryover is possible.

Here: significant trading activities, but holding stocks for investment, and not a trader (i.e., not engaged in the “business” of trading stocks).

The management of one’s financial investments is not engaging in a trade or business.  Here most securities were held for more than 1 year.

Business Interest Limitation              TCJA

§163(j), as amended in TCJA, disallows a deduction for the net business interest expense of a taxpayer which is in excess of 30% of the  adjusted taxable income of the business.

This limit does not apply to “small businesses,” i.e., having gross receipts less that $25 million.

Limitation does not apply to a trade or business of performing services.

Business interest is any interest paid or accrued on debt allocable to a trade or business.

Personal Interest                    p.606  

§163(h)(1) specifies:  no income tax deduction is available for personal interest (e.g., credit card interest).

Consider:  No gross income is imputed for income tax purposes from the use of personal property.

Therefore (to enable parallel treatment), no interest expense deduction should be available when purchasing personal property on credit.

Personal/Home Mortgage Interest                    p.606               

§163(h)(2)(D) exception for “qualified residence interest” to enable interest expense deduction.

§163(h)(3) defines “qualified residence interest”: (1) “acquisition indebtedness” (limit $1 million debt; but, $750,000 maximum during 2018-2025 – TCJA-2017), and,

(2) “home equity indebtedness” ($100,000) – this deduction is suspended during 2018-2025 – TCJA.

Pre 12-15-2017 debt is “grandfathered.”

Personal/Home Mortgage Interest, continued  p.606  

What about a reverse  mortgage? Home mortgage interest?

What is a “qualified residence” - §163(h)(4)(A).

Interest  on acquisition debt for second homes remains as permitted deduction after TCJA.

What was the legislative purpose of §163(h)(4)(C)?

Deduction for Taxes Paid
p. 610   

§164 permits a deduction of certain state and local taxes:  e.g., (1) income taxes;

(2) real and personal property taxes;  but,

(3) not sales taxes (except when?) 

TCJA-2017 – limit on annual deduction to $10,000 in aggregate – not indexed for inflation.

Who is most impacted by this limitation?

TCJA – no deduction for foreign real property tax – unless related to business.       continued

Deduction for Taxes Paid
p. 610, continued            

Other taxes paid may be deducted if the cost of the taxes is incurred for business or investment purposes.

Alternatively, cost might be required to be capitalized as part of the purchase price.

See below (slide 24):  Code §164(b)(5) election re state and local sales taxes as deductible (in lieu of state and local income tax).

Rev. Rul. 79-180               
p.611      Conflict of laws?

Under N.Y. “Real Property Tax Law” renters are treated as having an interest in real property and are personally liable for the real property taxes on the property.  Also:  the N.Y. law states that these persons are entitled to a federal itemized deduction for these taxes paid.

IRS holds:  This is not a real property tax imposed on the renter for FIT purposes.  No new economic burden has been imposed on renters from this N.Y. state legislation.

Discrimination when no State Income Tax?  p. 613        

Discrimination against a state (e.g., Texas) that does not (and will not) impose an income tax?  Is this a benefit for taxpayers deducting state income taxes?

See, however, §164(b)(5) re an election to deduct state and local sales taxes in lieu of deducting state and local income taxes. 

How determine the amount?  Estimates?

Permanent extension at end of 2015 (PATH Act of 2015).  Sponsor:  Rep. K. Brady (Houston).

Foreign Tax Credit
P. 615

An income tax credit (not a deduction) is available for the income taxes paid to foreign governments (including subnational governments). 

What is the value of a credit in this context?

Why provide a credit (rather than a deduction) in this context?

Does this produce a detrimental impact against states  (i.e., “subnational governments”) imposing taxes in the United States?

U.S. Estate Tax - Treatment re State Tax

Example of credit vs. deduction:

P. 615    U.S. estate tax computation -  previously in the U.S. a credit was provided against federal estate tax for death taxes paid to states.  E.g., state inheritance taxes and state estate taxes (“piggybacking taxes”).

Credit was repealed & the offset became a deduction for state death taxes paid - §2058.

Appropriate to use a deduction and not a tax credit?

Homeowners Benefits
& Tax Policy             p.615              

Are market distortions produced by (1) the home mortgage interest deduction and (2) the real estate tax deduction for the residence?

Producing discrimination against renters?

Cf., purchase of a condo vs. a co-op apartment.

Should the imputed home rental value for an owner-occupant be included in gross income?

Does availability of the tax deduction for tax and interest expense enable a “whip-saw”? 

Plus:  no inclusion of residence gain on sale.

Homeowners & Future Tax Policy               p. 618             

See effective tax rate on owner occupied housing – chart p. 620.  And, an upside-down effect?

See distribution of tax benefits from the home mortgage interest deduction – chart p. 621.

Policy options:

1) Replace interest expense deduction with a

credit equal to a percentage of the interest paid.

2) Limit the exemption of gain on residence sale.

3) Repeal state & local property tax deduction.

4) Enable a deduction for rent paid?

Casualty Losses & Personal Deduction  p.625   

§165(c)(3) enables (pre-2018) a deduction for losses from fire, storm, shipwreck, or other casualty, or from theft.  Is this a form of partial casualty insurance – reducing net loss amount?

Limitation on deduction to losses - only above 10% of AGI. §165(h)(2).  Why?

A loss limit per incident – must exceed $100.

Does claiming the deduction require an insurance claim?  See Code §165(h)(4)(E).

TCJA – limit to losses only in federal disasters.

William H. Carpenter
p. 626   

Inadvertent disposition by husband of wife’s diamond ring into the disposal was a “casualty” for §165(c)(3) purposes.  “Ejusdem generis.”

Ring was a total loss and claimed a $980 casualty loss deduction.

Fact determination by the judge based on the husband’s credibility.

The event was held to be an “other casualty” for §165(c)(3) purposes.  And,  no offset for cost of replacement.

Definition of a Casualty
p. 628   

What is a casualty (for §165 purposes)?

Fire, storm or shipwreck.

Hurricane Harvey.

Sudden or unexpected occurrence.

Termites – fast-eating vs. slow-eating termites.

Theft & “mysterious disappearance” – when was the theft discovered?

TCJA limit (2018-2025) to losses in federally declared disasters.  §165(h)(5) – until year 2026.

What Amount of Casualty Loss Deduction?

Reg. §1.165-7(b) – amount of the deduction is limited to lesser of (1) asset’s fair market value (when a depreciated asset), or (2) tax basis.

Problem 3(a) – p. 628

What was car’s fair market value before the accident?  Presumably not above $26,000.

Loss amount: This current fmv (e.g., $20,000) less $10,000 for  current casualty loss deduction amount - $10,000 (before the 10% floor).

What Amount of Casualty Loss Deduction?  Cont.

Reg. §1.165-7(b) – the amount of the deduction is limited to the lesser of (1) the asset’s fair market value (when a depreciated asset), or (2) tax basis.

Problem 3(b) – p. 628

Loss of $40,000 - $260,000 less $40,000 for land equals $220,000. See Reg. §1.165-7(b)(2)(ii) re “unit rule.”   Insurance:  then,  less $180,000 insurance proceeds equals $40,000 loss.

What Amount of Casualty Loss Deduction?  Cont.

Reg. §1.165-7(b) – the amount of the deduction is limited to the lesser of (1) the asset’s fair market value (when a depreciated asset), or (2) tax basis.

Prob. 3(c) – p. 628; Reg. §1.165-7(b)(1) & 8(c).

Loss by theft of property with $40,000 basis & $30,000 fair market value:

1) Personal item:  deduction of $30,000 (- $100).

2) Business item:  deduction of $40,000.

Did a “Casualty Loss” Really Occur?

Consider the result when appreciated property is lost in a casualty – the deduction is limited to the income tax basis.  §165(b). 

E.g., consider the theft of a highly appreciated item of jewelry.

What happens when the theft insurance proceeds are received in an amount in excess of the income tax basis for the item?

Chapter 10