8708 / Is the determination of a taxpayer’s allowable investment interest deduction coordinated with the passive loss rules?

The investment interest limitation is coordinated with the passive loss rules (see Q 8695 to Q 8704), so that interest and income subject to the passive loss rules are not taken into consideration under the investment interest limitation.¹ Interest expense incurred to purchase an interest in a passive activity is allocated to that passive activity and is not investment interest.²

However, portfolio income of a passive activity and expense (including interest expense) allocable to it is considered investment income and expense, not passive income and expense.³

Investment interest expense and investment income and expenses do not include items from a trade or business in which the taxpayer materially participates. The IRS has determined that interest on a loan incurred to purchase stock in a C corporation was investment interest (where the purchaser was not a dealer or trader in stock or securities), even though the purchaser acquired the stock to protect his employment with the C corporation.⁴

In a decision citing Revenue Ruling 93-68, the Tax Court held that interest on indebtedness incurred to purchase a taxpayer’s share of stock in a family-owned mortuary business was subject to the investment interest limitation, despite the fact that the taxpayer purchased the stock to conduct business full time and the fact that no dividends had been paid on the stock.⁵

Temporary regulations provide that, for purposes of the investment interest and passive loss rules, interest expense is generally allocated on the basis of the use of the proceeds of the underlying debt.