Federal Tax

Interest Expense Deductions (Portfolio 536)

  • The Portfolio Interest Expense Deductions describes in detail the basic rules relating to the allowance of and limitations on deductions for interest expenses as set forth in §163(a).


Bloomberg Tax Portfolio Interest Expense Deductions, No. 536, describes in detail the basic rules relating to the allowance of and limitations on deductions for interest expenses as set forth in the Internal Revenue Code and Treasury Regulations. Coverage includes: (1) the determination of whether payments are interest in form but not in substance, or vice versa; (2) the measurement and timing of interest deductions; (3) the investment interest limitation; (4) the nondeductibility of personal interest, including the “qualified residence interest” exception; (5) the various provisions for imputation of interest, including imputation of interest on certain types of below-market loans; (6) the interest capitalization rules; and (7) a survey of provisions disallowing interest.

Table of Contents

I. Introduction

II. Outline of Legislative History

A. Early History

B. The 1984 Act and the Time Value of Money

C. The Tax Reform Act of 1986

D. Post Tax Reform Act of 1986 Legislation

E. Tax Cuts and Jobs Act Changes

III. What Is “Interest”?

A. In General

B. Is There Valid “Indebtedness”?

C. Allocation of Payments to Interest and Principal

IV. Is It Interest in Form But Not in Substance?

A. Interest or Gift?

B. Interest or Profit-Sharing?

C. Interest or Purchase Price?

D. Interest or Payment for Services?

E. Interest or Dividend?

F. Interest or Partnership Distribution?

G. Tax-Motivated Transactions

V. Is It Interest in Substance Although Not in Form?

Introductory Material

A. Mortgage Points

B. Standby and Commitment Fees

C. Penalties

D. Statutory Mortgage Redemption Fee

E. Repurchase Premium

F. Sale-Leasebacks

G. Statutory Characterization as Interest

VI. Accounting Issues

Introductory Material

A. Method of Accounting

B. Capitalization

C. Special Situations

VII. Who Is Paying the Interest?

A. In General

B. Utilization of “Dummy” or Nominee Corporations to Avoid Usury Laws

C. Interest on Debts Secured Only by Property

D. Joint Obligors

E. Guarantors and/or Endorsers

F. Interest on Transferee Tax Liability

G. Cooperatives: Section 216

VIII. How Is Interest Classified?

A. Overview

B. Investment Interest

C. Passive Interest

D. Active Interest

E. What Is a “Qualified Residence?”

F. Married Couples Treated as One Taxpayer for Purposes of Qualified Residence Rules

G. Time-Sharing Arrangements

H. Residences After Destruction

I. Qualified Residence Interest

J. Interest Overcharge as Qualified Residence Interest

K. Estate Tax Extensions

L. Personal Interest

M. Student Loan Interest

N. Allocation Among Activities: Reg. §1.163-8T

O. Itemized or “Above the Line” Deduction

IX. Imputed Interest

Introductory Material

A. Below-Market Loans: Section 7872

B. Original Issue Discount (OID)

C. Bond Premium: Section 171

D. Section 483

E. Section 482

X. Special Statutory Disallowances and Deferrals

Introductory Material

A. Reduction of Itemized Deductions: Section 68 (“Pease Limitation”)

B. Loans from Qualified Plans: Section 72(p)

C. Investment Interest: Section 163(d)

D. “Registration-Required Obligations”: Section 163(f)

E. High-Yield Discount Obligations: Section 163(i)

F. Earnings Stripping: Pre-2018 §163(j)

G. Interest on Estate Tax Deferred Under Section 6166: Section 163(k)

H. Interest Payable in Equity: Section 163(l)

I. Corporate Equity Reduction Transactions: Former Section 172(b)(1)(D)

J. Hobby Losses: Section 183

K. Insurance: Section 264

L. Interest Related to Tax-Exempt Income: Section 265

M. Section 267 Matching Rules

N. Corporate Acquisition Indebtedness: Section 279

O. Interest Paid on Deposits, Etc.: Section 461(e)

P. At-Risk Limitation: Section 465

Q. Passive Activity Loss Limitation: Section 469

R. Interest Allocable to Accrued Discount

S. Order of Application of Rules

T. Section 163(j) Limitation on Deduction of Business Interest Expense

XI. Alternative Minimum Tax

XII. Tax Deficiency Interest

A. Status as Personal Interest

B. Effect of Taxpayer Contesting the Deficiency

C. Allocation of Tax, Interest and Penalties

D. Suspension of Interest

E. Interest on Transferee Liabilities

F. Interest on Underpayments from Undisclosed Reportable Transactions

G. Abatement of Underpayment Interest

Dominic Daher
Associate Vice President, Tax Compliance And Internal Audit
University Of San Francisco