The § 1.163-8T Rules for Allocating Interest Expense

Treasury Regulation § 1.163-8T provides the rules for allocating interest expense to determine its tax treatment. The regulation uses a tracing system that connects debt proceeds to specific expenditures, which classifies the associated interest. The character of the interest, such as deductible business interest or non-deductible personal interest, is determined by how the borrowed funds are used. This allocation must be monitored and sometimes adjusted over the life of the loan.

The Core Principle of Debt Tracing

The allocation of interest expense is determined by how debt proceeds are used, not by the property that secures the debt. For example, if an individual borrows money against their primary residence but uses the funds to purchase business equipment, the interest is traced to the business expenditure. This tracing allocates debt and interest into four main categories: Trade or Business, Passive Activity, Investment, and Personal.

A Trade or Business expenditure involves funds used in a business where the taxpayer materially participates. Interest allocated to this category is fully deductible against business income, allowing owners to reduce taxable income by financing operations like purchasing inventory.

Passive Activity expenditures relate to business activities where the taxpayer does not materially participate, such as owning rental properties. The deductibility of this interest is limited, as it can generally only be deducted against income from other passive activities, preventing the offset of active or portfolio income.

Investment expenditures are for acquiring property held for investment, like stocks and bonds. The deductibility of this investment interest is limited to the taxpayer’s net investment income, with any excess carried forward.

Personal expenditures cover all other uses of debt, such as for vacations or personal vehicles. Interest on personal debt is not deductible, with few exceptions like qualified residence interest on a home mortgage.

Tracing Rules for Commingled Funds

When debt proceeds are deposited into an account with other funds, specific ordering rules determine which expenditures are financed by the debt. The default rule is that any expenditure from a commingled account is treated as coming from borrowed funds first, until the debt proceeds are gone. For example, if $10,000 of loan proceeds are deposited into an account holding $5,000, the next $10,000 of expenditures are automatically allocated to the debt, regardless of the expenditure’s purpose.

An exception, the 30-day rule, provides flexibility. A taxpayer can treat any expenditure made from an account within 30 days before or after debt proceeds are deposited as being made from those proceeds. This election allows taxpayers to link debt to specific expenditures, like business purchases, overriding the default presumption.

Consider a small business owner with a single operating account. On June 1, the account has a $5,000 balance. On June 10, the owner takes out a $20,000 business loan and deposits the proceeds into the account. On June 25, the owner writes a $15,000 check for new business equipment, and on July 5, they pay $8,000 for a family vacation.

Under the general rule, the first expenditures are traced to the debt. The $15,000 equipment purchase would be allocated to the debt proceeds. Following that, the $8,000 vacation payment would also be traced to the debt, but only the remaining $5,000 of the loan proceeds would be allocated to it. The other $3,000 of the vacation cost would be considered paid from the original unborrowed funds.

Using the 30-day rule, the taxpayer can achieve a more favorable result. The equipment purchase on June 25 occurred within 30 days of the June 10 deposit, so the taxpayer can elect to treat that $15,000 expenditure as coming from the debt proceeds. This properly links the business debt to a business asset, while the vacation would be treated as coming from the remaining debt and the taxpayer’s own funds.

Debt Reallocation Upon Change in Circumstances

The initial debt allocation is not permanent and must be adjusted if the use of the asset financed by the debt changes. The rules require a reallocation of the debt when the underlying property is sold or its purpose is converted. This ensures the tax treatment of the interest expense continues to accurately reflect the use of the borrowed funds.

A primary trigger for reallocation is the sale of an asset acquired with debt proceeds. When this occurs, the debt is reallocated based on how the proceeds from the sale are used, following the same tracing rules as the original loan.

For instance, a taxpayer borrows $100,000 for business equipment. Later, they sell the equipment for $120,000 without repaying the loan and deposit the sale proceeds into a brokerage account to buy stocks. The $100,000 debt is reallocated from a business to an investment expenditure, and the interest becomes investment interest subject to deduction limitations.

Another event requiring reallocation is a change in an asset’s use, such as when a business vehicle is converted to personal use or a rental property becomes a primary residence. When the use of the asset changes, the allocation of the debt that financed it must change accordingly. If a taxpayer financed a business vehicle and later uses it solely for personal transport, the debt must be reallocated to a personal expenditure from the conversion date. The interest accruing after this date becomes non-deductible personal interest.

Rules for Refinancing and Debt Repayments

The rules also guide refinancing and loan repayments. When a loan is refinanced, the new “replacement debt” inherits the allocation of the old debt up to its outstanding balance. If new loan proceeds exceed the old debt’s balance, these excess funds are treated as a new loan. The interest on these excess proceeds is traced according to their specific use.

For example, if a $150,000 business loan is refinanced for $200,000, the first $150,000 of the new debt is allocated to business, while the extra $50,000 is allocated based on how it is spent.

A different set of ordering rules applies when making a payment on a single debt allocated to more than one type of expenditure. The regulations establish a specific repayment order that impacts which type of interest is eliminated first.

The repayment is first applied against amounts allocated to personal expenditures. Next, repayments are applied to investment and passive activity expenditures. The final portion repaid is that allocated to trade or business expenditures. This order is favorable to taxpayers because it eliminates non-deductible personal debt first, preserving the deductibility of other interest for as long as possible.

Special Scenarios and Considerations

Debt Proceeds Received in Cash

When loan proceeds are received in cash, a taxpayer can treat any cash expenditure made within 30 days before or after receiving the cash as being from those proceeds. This links cash borrowings to specific expenditures. If no election is made, the debt is treated as used for a personal expenditure.

Debt-Financed Distributions

For debt-financed distributions from pass-through entities like partnerships and S corporations, the process is multi-layered. When an entity borrows and distributes proceeds to its owners, the interest allocation is determined by how the owner uses the funds. The owner traces their use of the funds to classify the interest. Alternatively, the entity can allocate the debt and interest among its own assets using a reasonable method.

Debt Used to Pay Borrowing Costs

If loan proceeds are used to pay borrowing costs, like origination fees or interest on the same debt, a specific rule applies. Debt proceeds used to pay interest are allocated in the same manner as the underlying debt. For example, if a loan is 70% business and 30% personal, any proceeds used to pay interest on that loan are allocated in the same 70/30 split.