4B — September 15 - 28, 2017 — Northern New Jersey — M id A tlantic
Real Estate Journal
www.marejournal.com
N orthern N ew J ersey
By, Warren Wu, Sax LLP Debt-Financed Distributions: PLAN FOR YOUR PROCEEDS
ue to the prospect of mortgage interest rates rising, many real estate entities are considering refi- nancing their property to lock in lower rates and monetize a portion of their enterprise with a debt-financed distribution. A debt-financed distribution allows pass-through entities (Partnerships, S corporations, and Sole Proprietorships) to cash-out on a property’s appre- ciation and increased equity, and distribute those proceeds out to the entity’s owner(s). Under the general allocation rule, when debt proceeds are borrowed and then distributed D
to owners, the related interest expense has to be traced and allocated according to the use of the borrowed proceeds. The pass-through entity is responsi- ble for reporting the amount of interest expense that is related to the debt-financed distribu- tion, however, the burden to "trace" the expenditures that were made with these proceeds falls on the entities owner(s) – the recipients of the distribu- tions. It may be assumed that all the interest is deductible by the pass-through entity, but that is not always the case. De- ductibility depends on how the excess distributed proceeds are
used at the owner level. TRADE OR BUSINESS EXPENDITURES The interest expense on the debt proceeds related to the original business related debt balance right before the refinance, and any proceeds used to pay trade and busi- ness related expenditures, will continue to be a business related interest deduction by the entity. PASSIVE ACTIVITY EXPENDITURES If the proceeds are used in activities in which the taxpayer does not materially participate, the interest expense on that
portion will be allocated to the passive activity. As a pas- sive deduction, the interest in this case is subject to the pas- sive loss limitation rules and deducted against the passive activity. These passive rules may further limit the current deductibility of the interest unless the owner’s passive ac- tivities are in fact throwing off taxable income. HELD FOR INVESTMENT If the proceeds used to pur- chase property are used to purchase marketable securi- ties or other investments, the interest would be considered an investment interest expense,
the deductibility of which is limited to the amount of net investment income a taxpayer has each year. Unused invest- ment interest expenses can be carried forward indefinitely against future investment income. If the proceeds are used to purchase tax-exempt securities, the interest expense is non-deductible. PERSONAL EXPENDITURES If proceeds are used for per- sonal/consumer related purpos- es, like buying a personal car, a second home, or paying off personal credit card debt, the interest is not deductible at all. Decreasing Debt-Financed Distribution Interest Pass-through entities can use an alternative allocation method to decrease the amount of debt-financed distribution interest. Under this method, new debt proceeds are first allo- cated to the real estate entity’s current year expenditures, excluding non-cash expenses such as depreciation, and the related interest is treated as deductible business interest by the entity. Any excess proceeds, after allocating the proceeds to the payment of the entity’s current year expenditures, will follow the general allocation rule. Inmany instances this can significantly reduce the amount of interest that has to be sepa- rately tracked by the owner(s). Repayment of the entity’s debt in future years may first be allocated to reduce the sepa- rately stated interest related to any remaining debt-financed distribution. This can consid- erably reduce the number of years of non-deductible inter- est expense if the distribution proceeds were used for per- sonal purposes by the owners. Plan For Your Debt-Financed Owner Distributions It is essential to effectively plan before distributing pro- ceeds of any type to ensure you maximize the amount of related interest expense that is deductible. With careful tax planning, taxpayers can minimize non-deductible ex- penses and avoid creating an unintended result. Warren Wu, CPA is a Tax Manager at Sax and a mem- ber of the firm’s Real Estate Practice. He specializes in tax services for property owners, developers, and investors. n
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