What Is IRS Notice 89-35? A Look at Interest Tracing

IRS Notice 89-35 provides guidance for taxpayers on how to allocate interest expense. The purpose of this notice is to establish a clear connection between borrowed funds and their ultimate use, which determines the tax treatment of the interest paid. The rules dictate whether interest is a deductible business or investment expense, or if it falls into the non-deductible personal category.

The notice establishes the framework for this process, providing a method for tracing loan proceeds from the moment they are received to the point they are spent. This ensures that the character of the interest expense directly reflects the nature of the expenditure it funded. This approach applies to individuals, partnerships, and corporations when handling the tax implications of interest payments.

The Core Principle of Debt Tracing

The foundation of the interest allocation rules is tracing. This principle dictates that the tax deductibility of interest is determined by the actual use of the borrowed funds, not by the asset used as collateral for a loan. For example, if a taxpayer borrows against their primary residence but uses the money for business equipment, the interest is traced to the business use, not the personal residence.

This tracing mechanism sorts interest into specific categories with different tax consequences. Trade or business interest, which is fully deductible, arises from debt used for expenditures in a taxpayer’s active business operations. Investment interest, deductible up to the amount of net investment income, comes from debt used to purchase assets like stocks and bonds.

Passive activity interest is tied to debt used in rental activities or businesses in which the taxpayer does not materially participate. Personal interest is a broad category for any interest that does not fall into the other classifications, such as loans for personal consumption. Under current tax law, personal interest is generally not deductible.

Applying the Tracing Rules to Expenditures

The application of tracing rules is straightforward when loan proceeds are deposited into a new, separate bank account. In this scenario, any expenditure from that account is traced to the debt, and the character of the interest expense is determined by that expenditure. The process becomes more complex when loan proceeds are deposited into a commingled account, which contains both borrowed funds and other money.

To address commingled accounts, regulations provide specific ordering rules. Notice 89-35 allows taxpayers to treat expenditures made within 30 days before or 30 days after the debt proceeds are deposited as being funded by the loan. If no specific expenditure is designated within this window, the funds are generally treated as used for personal purposes.

Consider a practical example: a business owner borrows $20,000 and deposits it on June 1st into a business checking account that already holds $5,000. On June 10th, the owner purchases $15,000 of new inventory. On June 25th, they pay a $3,000 personal credit card bill from the same account.

Because the inventory purchase occurred within 30 days of the deposit, the owner can trace $15,000 of the debt to that business expenditure, making the associated interest a deductible business expense. The remaining debt may be allocated to the personal expense, rendering that portion of the interest non-deductible. The 30-day window offers a practical safe harbor for linking funds to expenditures.

Allocations for Pass-Through Entities

Notice 89-35 provides special rules for pass-through entities like S corporations and partnerships. These rules address two primary situations: when an owner borrows to acquire an interest in the entity, and when the entity borrows and distributes the funds to its owners.

In a debt-financed acquisition, where a partner or shareholder borrows to buy their ownership stake, the interest expense allocation can be handled in two ways. The taxpayer can allocate the debt among all the entity’s assets using a reasonable method, such as pro-rata valuation. Alternatively, they can trace the debt proceeds to the entity’s expenditures during the year, determining the interest’s character by the entity’s activities.

When the entity takes on debt and makes a debt-financed distribution to its owners, the general rule requires tracing the funds to the owner’s specific use. If an owner uses the distributed cash for a personal boat, the interest allocated to them is non-deductible personal interest. However, an optional rule allows the entity to allocate the debt proceeds to its own operating expenditures made during the same tax year, which can convert personal interest at the owner level into a deductible business expense.

Reporting and Recordkeeping Requirements

Once interest expense has been traced and allocated, it must be reported on the correct tax forms. Interest allocated to a trade or business is reported on Schedule C for sole proprietors or Form 1120S or 1065 for pass-through entities. Investment interest is reported on Form 4952, Investment Interest Expense Deduction, and the deductible amount is carried to Schedule A (Form 1040).

To support these deductions, taxpayers must maintain records, as the burden of proof lies with the taxpayer during an IRS examination. Documents include loan agreements establishing the debt terms and bank statements showing the deposit of loan proceeds and subsequent expenditures.

A written allocation statement should also be kept with tax records. This document should identify the loan, the date proceeds were received, the account they were deposited into, and a detailed list of the expenditures to which the debt was allocated. For pass-through entities making debt-financed distributions, the entity reports the owner’s share of interest on Schedule K-1 as “interest expense allocated to debt-financed distributions.”