Revenue Ruling 82-55 and Disallowed Interest Deductions
Explore the IRS principle that disallows interest deductions for loans secured by tax-advantaged assets, preventing a double tax benefit.
The Internal Revenue Service provides specific guidance on the deductibility of interest expenses, particularly when loan proceeds are linked to tax-advantaged investments. The rule, found in the Internal Revenue Code, is designed to prevent a double tax benefit.
The Core Principle of the Disallowance Rule
The fundamental concept is the prevention of a double tax benefit. This situation arises when a taxpayer attempts to deduct interest paid on a loan while simultaneously earning tax-exempt income from an asset purchased or carried with the loan proceeds.
This has been a long-standing feature of the tax code. The most common application today involves tax-exempt municipal bonds.
This principle ensures that the tax system maintains a consistent approach to deductions and income. Allowing an interest deduction on debt used to carry a tax-exempt asset would effectively create a government-subsidized investment. The rule closes this potential loophole by directly linking the interest expense to the tax-exempt income it helps to generate. The focus is on the purpose of the debt and its relationship to the tax-advantaged asset.
Scenarios Covered by the Principle
The provision governing these scenarios is Internal Revenue Code Section 265. This section states that no deduction is allowed for interest on indebtedness incurred or continued to purchase or carry obligations that pay interest wholly exempt from federal income tax. The most common modern example of this is using tax-exempt municipal bonds as collateral for a loan.
If an individual owns municipal bonds, which generate tax-free interest, and pledges those specific bonds to secure a bank loan, the IRS will consider this direct evidence that the loan was “continued to carry” the tax-exempt asset. Consequently, the interest paid on that loan becomes non-deductible. The act of using the tax-exempt asset as collateral creates the direct relationship that triggers the disallowance.
The principle can also apply in less direct circumstances. Procedural guidance outlines how the IRS will infer a connection based on the totality of facts and circumstances. For instance, if a taxpayer with significant municipal bond holdings takes out a large loan without a clear business purpose and lacks other liquid assets to justify the borrowing, the IRS might infer a connection.
Calculating the Disallowed Interest
Determining the amount of disallowed interest is a straightforward comparison. The portion of the loan interest that is not deductible is the lesser of two amounts: the total interest paid on the loan for the tax year or the total tax-exempt interest earned from the related asset during that same year. This calculation ensures that the disallowed deduction does not exceed the tax benefit received.
To illustrate, consider a taxpayer who paid $3,000 in interest on a loan that was secured by tax-exempt municipal bonds. During the same year, those specific bonds generated $2,500 in tax-free interest income. In this case, the disallowed portion of the loan interest is $2,500, as it is the lesser of the $3,000 interest paid and the $2,500 tax-exempt interest earned. The taxpayer would only be able to deduct the remaining $500 of loan interest, assuming it is otherwise deductible.
If the situation were reversed, where the taxpayer paid $3,000 in loan interest but the collateralized bonds earned $3,500 in tax-exempt interest, the entire $3,000 of loan interest would be disallowed. This is because the interest paid is less than the tax-exempt income generated by the asset securing the debt.
Tax Reporting Requirements
The instructions for Form 4952, Investment Interest Expense Deduction, explicitly state that interest expense on debt used to carry tax-exempt securities is not deductible. This amount should not be included on the form.
For example, if a taxpayer paid $5,000 in total investment interest but determined that $1,500 of it was disallowed, they would not report the full $5,000 as deductible. Instead, they would reduce the total by the disallowed amount and claim only the net figure of $3,500 on the appropriate line of Form 4952. It is important to maintain records documenting both the total interest paid and the calculation for the disallowed portion in case of an IRS inquiry.