1. Section 163 – Deductibility of Interest

2. Section 163(a) states: “There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.” Sec. 163(a) is identified as the general rule, but that is no longer accurate. Business interest continues to be deductible. For individuals, the exceptions to deductibility swallow up the general rule of allowance.

3. For individuals, sec. 163(d)(1) permits deduction of investment interest only to the extent of investment income.

4. Example: I borrow money to buy bonds and stock and pay $1200 in interest on that loan in Year 1. I get $1000 in payment of interest and dividends in Year 1. How much of the interest I paid can I deduct? Answer: $1000

5. Example: I borrow money to buy stock and pay $1200 in interest on that loan in Year 1. The stock appreciates in value but pays no dividends in Year 1. How much of the interest paid can I deduct? Answer: None

6. Why do we have this limit on deductibility of investment interest? To match income and expense. To prevent current deduction with deferred taxation of property appreciation – time value of money.

7. Sec. 163(h) allows no deduction for personal interest except for “qualified residence interest.” There are two categories of “qualified residence interest.” Acquisition indebtedness Home equity indebtedness

8. Acquisition indebtedness Limit of $1 million total in principal. Debt incurred in acquiring, constructing or substantially improving any qualified residence of the taxpayer. Secured by the residence. Refinancing limited to outstanding debt at time of refinancing. Principal residence and one other residence used as such

9. Home equity indebtedness Limit of $1000,000 total in principal Indebtedness secured by residence Also limited to excess of FMV of residence reduced by amount of acquisition indebtedness Can be used for ANY purpose.

10. Acquisition or Home Equity Indebtedness? I made a down payment of $100k and borrowed $600k to buy my house When $600k of debt is still outstanding, I borrow $100k to add a new room. Instead, I borrow $100k to buy furniture for it. Instead, I borrow $100k to buy a car, pay for cosmetic surgery and send my kids to college.

11. Examples from textbook

12. Qualified residence interest raises a key question of horizontal equity.

13. Consider Alice. Alice owns taxable bonds worth $500k and borrows $100k to buy a condo. Her bonds earn interest at 10%. She can borrow at 10%. If her mortgage interest is deductible, she has a house, $50k of interest income, a $10k mortgage interest deduction. This gives her net $40k of taxable income.

14. Consider Barbara. Barbara has $500k of taxable bonds. She sell $100k of the bonds to buy a condo. She now has $400k of bonds. If they pay 10%, she will have $40k of taxable income. She and Alice will be similarly situated.

15. Consider Carol. She earns $50k in salary. She is not able to borrow to buy a house. She rents at a cost of $10k a year. But since she cannot deduct her rent, her taxable income is $50k.

16. The horizontal equity problem could be solved by imputing income for the rental value of a residence. Interest would then be appropriately deducted as part of the cost of earning such income. Imagine imputed rental income of $10k per year and interest deduction of $10k per year.

17. What would happen in each case if we imputed such income? A who did not sell bonds but borrowed to buy would have $60k of income ($50 of interest income on her bonds and $10k of imputed income on house) and a $10k mortgage interest deduct for $50k of taxable income. B who sold bonds in order to buy but did not borrow would have $50k of income ($40k of interest income and $10k of imputed income on the house) and no deductions for $50k of taxable income. C who could not sell assets or borrow but rented would have $50k of taxable income from salary and no deductions for $50k of taxable income.

18. Section 265(a) disallows any interest deduction for indebtedness incurred or continued to purchase or carry tax-exempt obligations. What are tax-exempt obligations? State and municipal bonds. See sec. 103.

19. Why do we have this rule of sec. 265(a)(2)? To prevent arbitrage – an important concept. Arbitrage is taking advantage of different rates on two sides of a transaction. In this case, the rule prevents taking in tax-exempt interest and paying tax-deductible interest.

20. In a world without sec. 265(a)(2) Sam could buy $100k of municipal bonds paying 8%. Sam would thus get $8k tax-free each year. Sam could borrow $100k to buy these bonds, pledging the bonds as security, at 10%. Paying $10k in interest and getting $8k in income would not be crazy. If the interest paid were deductible and Sam’s marginal rate were 30%, the interest cost would be only $7k after taxes. Sam would come out $1k ahead without using any of his own money.

21. Under 265(a)(2), how close of a connection must there be? Simultaneous existence is not enough. BUT any time you borrow to purchase a new asset, you borrow not only to get the new one, but also to avoid disposing of an old asset.

22. Tests for section 265(a)(2) Direct evidence of a purpose to buy tax-exempts Pledging currently-owned tax- exempts as security for new loan. Generally, borrowing to purchase or improve a residence is okay, even if you own tax-exempts. Having a home mortgage and then using new funds to buy tax-exempts is probably okay. Less certainty with home equity indebtedness, although folks generally do no worry about this.

23. With all these different treatments of interest on different kinds of loans, how do we know which rule applies? Generally, we use a tracing rule – we look to see what the money was used for. Usually, security for the loan does not matter. Security does matter for sec. 163(h), especially for home equity loans, and for sec. 265(a)(2).

24. Example Arthur and Beatrice each have $10k in savings. Each plans to borrow $10k. Each plans to buy $10k in corporate bonds and a $10k pleasure boat.

25. Arthur uses the cash to buy the bonds and borrows to buy the boat. Arthur gets no interest deduction because the borrowed funds were used for personal consumption.

26. Beatrice uses the cash to buy the boat and borrows to buy the bonds. Beatrice can deduct the interest on the loan to the extent B receives interest on the bonds.

27. We do this even though both end up in the same place – with a boat, bonds, and a $10,000 debt. We could have said that for both, half of the debt is personal and half for investment. Treasury considered but rejected such a pro rate rule as too complicated.

28. General advice is to have separate bank accounts for borrowed funds for different purposes. If borrowed funds are mixed with non-borrowed funds in the same account, we treat them as if borrowed funds are oil and the other money is water. The regulations assume that after 15 days, the borrowed funds rise to the top and whatever thereafter comes out of the account comes first from borrowed funds.

29. Tracing problems in text

30. Section 221 allows a deduction of up to $2500 for interest on loans for higher education of the taxpayer, spouse, or dependent. The allowable deduction is phased out as income increases above $50k ($100k for joint returns). The phase-out requires that a fraction be calculated as specified in the code. The $2500 deduction will be REDUCED by that fraction.