Tax Court Illustrates the Interest Tracing Rules

Tax Court Illustrates the Interest Tracing Rules

On Wednesday, we posted a quick tutorial on how to determine the deductible amount of mortgage interest when total mortgage debt exceeds the statutory limits. While we briefly mentioned that any interest in excess of the allowable amount was subject to the interest tracing rules, we failed to expand further on this concept.

Lucky for us, on Thursday the Tax Court explained the interest tracing principles beautifully, providing a ready-made supplement to our previous post. [i]

Robert Brooks (Brooks) worked for DainRauscher(Dain) as a stock broker. As part of his compensation, Dainlent him more than $500,000, which Brooks promised to repay, including accrued interest. Dain, however, promised to forgive the loan, including the accrued interest, if Brooks remained a Dain employee. [ii]

In 2003 Dain forgave the entire loan and included $650,342 ($506,300 in principal and $144,042 of accrued interest) on Brooks’ 2003 Form W-2. Brooks recognized the income on his 2003 tax return, but upon a subsequent IRS audit, he changed his position and argued that the accrued interest of $144,042 should not have been included in income.

The basis for Brooks’ argument lay in I.R.C. § 108(e)(2). In general, I.R.C. § 61 requires all cancellation of indebtedness (COD)income — including cancellation of any accrued but unpaid interest — to be included in income of the debtor. An exception to this general rule is found in I.R.C. § 108(e)(2), however, which provides that a debtor will not realize COD income to the extent payment of the liability would’ve given rise to a deduction.

Thus, the determination of whether Brooks could exclude the forgiven interest depends entirely on whether it would have been deductible on Brooks 2003 tax return had he actually paid it: if it would have been, Brooks could exclude the income; if it would not have been deductible, then the forgiven interest must be included in Brooks’ taxable income.

To determine the deductibility of the interest, the interest tracing rulesmust be applied. These rules generally allocate interest expense based on the use of the debt proceeds. Stated in another manner, Brooks was required to prove what the money borrowed from Dainwas used for; if it was used in a trade or business, to generate investment income, or for the production of income under I.R.C. § 212; the underlying interest would be deductible as business interest, investment interest, or I.R.C. § 212 interest, respectively. To the contrary,if the proceeds were used for personal purposes, any interest would be non-deductible personal interest. [iii]

Brooks argued that the loan proceeds were used to purchase shares of stock, and thus the underlying interest should be deductible as investment interest. The Tax Court disagreed, for two reasons:

1. Brooks did not provide adequate support for how the borrowed funds were used. The only proof he provided was to point to the long list of stock transactions he attached to his 2003 return, which the court held was not sufficient to “trace” the use of the funds. [iv]

2. Even if the use of the funds could be traced to the purchase of stock, the interest would be investment interest, which is subject to limitation. Investment interest is only deductible to the extent a taxpayer has “net investment income,” defined as investment income less related expenses. Because Brooks had no net investment income in 2003, no investment interest would have been deductible by Brooks even if paid in 2003. Since payment of the interest would not have given rise to a deduction, I.R.C. § 108(e)(2) would not apply, and Brooks would be required to include the forgiven interest in income.