Pass-through entities, especially partnerships, frequently invest in real estate as a strategic financial move. These entities utilize real estate investments to leverage tax advantages, generate income, and diversify their portfolios. By holding property, they can benefit from appreciation, rental income, and potential tax deductions, making real estate a valuable asset in their investment strategies.

As the property's value appreciates, refinancing to access the equity can become an attractive option. When a business borrows funds and distributes those funds to its members, this may result in a debt-financed distribution.

There are two methods for allocating the debt proceeds and related interest: general interest allocation and optional allocation. Under the general interest allocation method, the debt proceeds and related interest are allocated based on how each member uses the proceeds. Consequently, the deductibility of the interest expense varies and can be treated in one of four ways.

1. Personal: the interest expense would not be deductible. For example, James uses the distribution to pay for a water heater for his primary residence.

2. Investment: the interest is deductible but limited to net investment income. For instance, Jack uses the distribution to purchase stock in a publicly traded company.

3. Passive: the interest is deductible to the extent of passive activity rules. For example, Julia uses the distribution to purchases an interest in a limited partnership.

4. Active: the interest expense is deductible. For instance, Jennifer uses the distribution to purchase tools for her sole proprietorship.

The interest expense related to the distributed funds will be separately stated on the member's Schedule K-1. Consequently, depending on how the distributed funds are used, as mentioned above, the interest expense will be reported on their individual income tax return.

On the other hand, the optional allocation rule allows a pass-through entity to allocate the debt proceeds and related interest to expenditures made during the same year, excluding distributions. As a result, if the expenditures exceed the distributions, there may be no debt-financed distributions. Distributed debt proceeds in excess of any expenditures will follow the general interest allocation method. For instance, a business refinances to a new loan of $2,000,000 and $500,000 is used to pay off the original loan. The remaining $1,500,000 is distributed to its members. During the tax year, the business also incurred $850,000 in expenditures and other debt has not been allocated to these expenditures. As a result, the business chooses to allocate $850,000 of the distributions to business expenses, following the optional allocation rule. The business can deduct interest related to the $850,000. The remaining interest expense related to the $650,000 would be separately stated as debt-financed distributions, following the general interest allocation method. The deductibility of the interest would depend on how each member uses the proceeds.

It is important to understand the options for handling debt-financed distributions as there are pros and cons to the various methods. Please reach out to us if you would like to evaluate this as it relates to your real estate investments.