The rules for deducting interest vary, depending on whether the loan proceeds are used for business, personal, investment, or passive activities. If you use the proceeds of a loan for more than one type of expense, you must make an allocation to determine the interest for each use of the loan's proceeds.

Allocate your interest expense to the following categories.

• Trade or business interest
• Passive activity interest
• Investment interest
• Portfolio interest
• Personal interest

In general, you allocate interest on a loan the same way you allocate the loan proceeds. You allocate loan proceeds by tracing disbursements to specific uses.

The easiest way to trace disbursements to specific uses is to keep the proceeds of a particular loan separate from any other funds.

Secured loan. The allocation of loan proceeds and the related interest is not generally affected by the use of property that secures the loan.

Example. You secure a loan with property used in your business. You use the loan proceeds to buy an automobile for personal use. You must allocate interest expense on the loan to personal use (purchase of the automobile) even though the loan is secured by business property.

If the property that secures the loan is your home, you generally do not allocate the loan proceeds or the related interest. The interest is usually deductible as qualified home mortgage interest, regardless of how the loan proceeds are used. For more information, see Publication 936.

Allocation period. The period for which a loan is allocated to a particular use begins on the date the proceeds are used and ends on the earlier of the following dates.

• The date the loan is repaid.
• The date the loan is reallocated to another use.

Proceeds not disbursed to borrower. Even if the lender disburses the loan proceeds to a third party, the allocation of the loan is still based on your use of the funds. This applies whether you pay for property, services, or anything else by incurring a loan, or you take property subject to a debt.

Proceeds deposited in borrower's account. Treat loan proceeds deposited in an account as property held for investment. It does not matter whether the account pays interest. Any interest you pay on the loan is investment interest expense. If you withdraw the proceeds of the loan, you must reallocate the loan based on the use of the funds.

Example. Connie, a calendar-year taxpayer, borrows $100,000 on January 4 and immediately uses the proceeds to open a checking account. No other amounts are deposited in the account during the year and no part of the loan principal is repaid during the year. On April 1, Connie uses $20,000 from the checking account for a passive activity expenditure. On September 1, Connie uses an additional $40,000 from the account for personal purposes.

Under the interest allocation rules, the entire $100,000 loan is treated as property held for investment for the period from January 4 through March 31. From April 1 through August 31, Connie must treat $20,000 of the loan as used in the passive activity and $80,000 of the loan as property held for investment. From September 1 through December 31, she must treat $40,000 of the loan as used for personal purposes, $20,000 as used in the passive activity, and $40,000 as property held for investment.

Order of funds spent. Generally, you treat loan proceeds deposited in an account as used (spent) before either of the following.

• Any unborrowed amounts held in the same account.
• Any amounts deposited after these loan proceeds.

Example. On January 9, Edith opened a checking account, depositing $500 of the proceeds of Loan A and $1,000 of unborrowed funds. The following table shows the transactions in her account during the tax year.

Date	Transaction
January 9	$500 proceeds of Loan A and $1,000 unborrowed funds deposited
January 13	$500 proceeds of Loan B deposited
February 18	$800 used for personal purposes
February 27	$700 used for passive activity
June 19	$1,000 proceeds of Loan C deposited
November 20	$800 used for an investment
December 18	$600 used for personal purposes

Edith treats the $800 used for personal purposes as made from the $500 proceeds of Loan A and $300 of the proceeds of Loan B. She treats the $700 used for a passive activity as made from the remaining $200 proceeds of Loan B and $500 of unborrowed funds. She treats the $800 used for an investment as made entirely from the proceeds of Loan C.

Edith treats the $600 used for personal purposes as made from the remaining $200 proceeds of Loan C and $400 of unborrowed funds. Note that for the periods during which loan proceeds are held in the account, they are treated as property held for investment.

Payments from checking accounts. Generally, you treat a payment from a checking or similar account as made at the time the check is written if you mail or deliver it to the payee within a reasonable period after you write it. You can treat checks written on the same day as written in any order.

Amounts paid within 30 days. If you receive loan proceeds in cash or if the loan proceeds are deposited in an account, you can treat any payment (up to the amount of the proceeds) made from any account you own, or from cash, as made from those proceeds. This applies to any payment made within 30 days before or after the proceeds are received in cash or deposited in your account.

If the loan proceeds are deposited in an account, you can apply this rule even if the rules stated earlier under Order of funds spent would otherwise require you to treat the proceeds as used for other purposes. If you apply this rule to any payments, disregard those payments (and the proceeds from which they are made) when applying the rules stated under Order of funds spent.

If you received the loan proceeds in cash, you can treat the payment as made on the date you received the cash instead of the date you actually made the payment.

Example. Frank gets a loan of $1,000 on August 4 and receives the proceeds in cash. Frank deposits $1,500 in an account on August 18 and on August 28 writes a check on the account for a passive activity expense. Also, Frank deposits his paycheck, deposits other loan proceeds, and pays his bills during the same period. Regardless of these other transactions, Frank can treat $1,000 of the deposit he made on August 18 as being paid on August 4 from the loan proceeds. In addition, Frank can treat the passive activity expense he paid on August 28 as made from the $1,000 loan proceeds treated as deposited in the account.

Optional method for determining date of reallocation. You can use the following method to determine the date loan proceeds are reallocated to another use. You can treat all payments from loan proceeds in the account during any month as taking place on the later of the following dates.

• The first day of that month.
• The date the loan proceeds are deposited in the account.

However, you can use this optional method only if you treat all payments from the account during the same calendar month in the same way.

Interest on a separate account. If you have an account that contains only loan proceeds and interest earned on the account, you can treat any payment from that account as being made first from the interest. When the interest earned is used up, any remaining payments are from loan proceeds.

Example. You borrowed $20,000 and used the proceeds of this loan to open a new savings account. When the account had earned interest of $867, you withdrew $20,000 for personal purposes. You can treat the withdrawal as coming first from the interest earned on the account, $867, and then from the loan proceeds, $19,133 ($20,000 - $867). All of the interest charged on the part of the loan from the time it was deposited in the account until the time of the withdrawal is investment interest expense. The interest charged on the part of the proceeds used for personal purposes ($19,133) from the time you withdrew it until you either repay it or reallocate it to another use is personal interest expense. The interest charged on the loan proceeds you left in the account ($867) continues to be investment interest expense until you either repay it or reallocate it to another use.

Loan repayment. When you repay any part of a loan allocated to more than one use, treat it as being repaid in the following order.

1. Personal use.
2. Investments and passive activities (other than those included in (3)).
3. Passive activities in connection with a rental real estate activity in which you actively participate.
4. Former passive activities.
5. Trade or business use and to expenses for certain low-income housing projects.

Line of credit (continuous borrowings). The following rules apply if you have a line of credit or similar arrangement.

1. Treat all borrowed funds on which interest accrues at the same fixed or variable rate as a single loan.
2. Treat borrowed funds or parts of borrowed funds on which interest accrues at different fixed or variable rates as different loans. Treat these loans as repaid in the order shown on the loan agreement.

Loan refinancing. Allocate the replacement loan to the same items to which the repaid loan was allocated. Make the allocation only to the extent you use the proceeds of the new loan to repay any part of the original loan.

Partnerships and S Corporations

The following rules apply to the allocation of interest expense in connection with debt-financed acquisitions of interests in partnerships and S corporations. These rules also apply to the allocation of interest expense in connection with debt-financed distributions from partnerships and S corporations.

These rules do not apply if the partnership or S corporation is formed or used for the principal purpose of avoiding the interest allocation rules.

Debt-financed acquisition. A debt-financed acquisition is the use of loan proceeds to buy an interest in a partnership or S corporation or to make a contribution to the capital of one.

You must allocate the loan proceeds and the related interest expense among all the assets of the entity. You can use any reasonable method. If you buy an interest in a partnership or S corporation (other than by way of a contribution to capital), reasonable methods include a pro rata allocation based on the fair market value, book value, or adjusted basis of the assets, reduced by any debts allocated to the assets.

If you contribute to the capital of a partnership or S corporation, reasonable methods ordinarily include allocating the debt among all the assets or tracing the loan proceeds to the entity's expenditures.

Treat the purchase of an interest in a partnership or S corporation as a contribution to capital to the extent the entity receives any proceeds of the purchase.

Example. You buy an interest in a partnership for $20,000 using borrowed funds. The partnership's only assets include machinery used in its business valued at $60,000 and stocks valued at $15,000. You allocate the loan proceeds based on the value of the assets. Therefore, you allocate $16,000 of the loan proceeds ($60,000/$75,000 x $20,000) and the interest expense on that part to trade or business use. You allocate the remaining $4,000 ($15,000/$75,000 x $20,000) and the interest on that part to investment use.

Reallocation. If you allocate the loan proceeds among the assets, you must make a reallocation if the assets or the use of the assets change.

How to report. Individuals should report their deductible interest expense on either Schedule A or Schedule E of Form 1040, depending on the type of asset (or expenditure if the allocation is based on the tracing of loan proceeds) to which the interest expense is allocated.

For interest allocated to trade or business assets (or expenditures), report the interest in Part II, Schedule E (Form 1040). On a separate line, put "business interest" and the name of the partnership or S corporation in column (a) and the amount in column (i).

For interest allocated to passive activity use, enter the interest on Form 8582 as a deduction from the passive activity of the partnership or S corporation. Show any deductible amount in Part II, Schedule E (Form 1040). On a separate line, put "passive interest" and the name of the entity in column (a) and the amount in column (g).

For interest allocated to investment use, enter the interest on Form 4952. Carry any deductible amount allocated to royalties to Part II, Schedule E (Form 1040). On a separate line enter "investment interest" and the name of the partnership or S corporation in column (a) and the amount in column (i). Carry the balance of the deductible amount to line 13, Schedule A (Form 1040).

Any interest allocated to proceeds used for personal purposes is generally not deductible.

Debt-financed distribution. A debt-financed distribution occurs when a partnership or S corporation borrows funds and allocates those funds to distributions made to partners or shareholders. The distributed loan proceeds and related interest expense must be reported to the partners and shareholders separately. This is because the loan proceeds and the interest expense must be allocated depending on how the partner or shareholder uses the proceeds.

This treatment of debt-financed distributions follows the general allocation rules discussed earlier. For example, if a shareholder uses distributed loan proceeds to invest in a passive activity, that shareholder's portion of the entity's interest expense on the loan proceeds is allocated to a passive activity use.

Optional allocation method. The partnership or S corporation can choose to allocate the distributed loan proceeds to other expenditures it makes during the tax year of the distribution. This allocation is limited to the difference between the other expenditures and any loan proceeds already allocated to them. For any distributed loan proceeds that are more than the amount allocated to the other expenditures, the rules in the previous paragraph apply.

How to report. If the entity does not use the optional allocation method, it reports the interest expense on the loan proceeds on the line on Schedule K-1 ( Form 1065 or Form 1120S) for "Other deductions." The expense is identified on an attached schedule as "Interest expense allocated to debt-financed distributions." The partner or shareholder claims the interest expense depending on how the distribution was used.

If the entity uses the optional allocation method, it reports the interest expense on the loan proceeds allocated to other expenditures on the appropriate line or lines of Schedule K-1. For example, if the entity chooses to allocate the loan proceeds and related interest to a rental activity expenditure, the entity will take the interest into account in figuring the net rental income or loss reported on Schedule K-1.

More information. For more information on allocating and reporting these interest expenses, see Notice 88-37 in Cumulative Bulletin 1988-1. Also see Notice 89-35 in Cumulative Bulletin 1989-1.

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