Many pass-through entities, including limited liability companies, are often tempted to cash out on the appreciation of their real estate holdings through refinancing. The members then have the discretion to use these funds as they see fit, including investing in other properties and projects or for personal use. It is often assumed that interest on the new mortgage is fully deductible for income tax purposes; however, that is not necessarily the case.
Interest Tracing of Debt-Financed Distributions
When a partnership distributes some or all of the proceeds from a debt, the distribution is called a debt-financed distribution. Under the interest tracing rules, the recipients of the debt-financed distributions are required to trace the expenditures made with the distributed proceeds in order to properly allocate the interest expense.
Interest Deductibility
After each recipient of debt-financed distributions traces how the funds were used, they must then classify 
the expenditures in one of four categories:
- Personal expenditures – personal interest expense is generally not deductible. An example would be using the proceeds to pay off a credit card debt.
- Trade or business expenditures – funds are used in an expenditure that you are actively engaged in for profit. Let’s say the sole proprietor of a law firm purchases a computer server with the proceeds from a debt financed distribution. The portion of the interest expense used to purchase the computer server would be deductible on the owner’s Schedule C.
- Passive activity expenditures – if proceeds are used by the member to make an investment in a separate partnership or pay expenses on behalf of an entity in which he does not materially participate, the interest would be subject to the rules governing passive activities (see my previous blog on Passive Loss Limitations).
For example: Bill receives $100,000 in debt-financed distributions from his investment in a real estate partnership. He then uses that money to invest in a new LLC that purchased rental real estate. The interest expense related to the $100,000 of proceeds will be used to compute Bill’s net income or loss from his passive activities on Schedule E. - Investment activity expenditures – if the proceeds are used in investment activities, the interest is treated as investment interest expense.
For instance, Bill used the proceeds to purchase Apple stock. The interest expense is reported on Form 4952 (Investment Interest Expense Deduction), and is potentially deductible on Schedule A as an itemized deduction.
If you are a member of a partnership or other entity with real estate holdings, and are considering cashing out and investing your debt-financed distribution in other assets, be sure to consult a tax professional to ensure your audit trail is complete.
