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

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.

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.

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.

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.

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

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.

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.

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.

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.

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.

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

The following rules apply if you have a line of credit or similar arrangement.

Allocate the replacement loan to the same uses 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.

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

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.

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

Individuals should report their share of deductible partnership or S corporation 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 (h).

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 (f).

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 (h). 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.

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 or 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 S corporation's interest expense on the loan proceeds is allocated to a passive activity use.

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.

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 takes the interest into account in figuring the net rental income or loss reported on Schedule K–1.

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.

If you are liable for part of a business debt, you can deduct only your share of the total interest paid or accrued.

Generally, mortgage interest paid or accrued on real estate you own legally or equitably is deductible. However, rather than deducting the interest currently, you may have to add it to the cost basis of the property as explained later under Capitalization of Interest.

If you paid $600 or more of mortgage interest (including certain points) during the year on any one mortgage, you generally will receive a Form 1098 or a similar statement. You will receive the statement if you pay interest to a person (including a financial institution or a cooperative housing corporation) in the course of that person's trade or business. A governmental unit is a person for purposes of furnishing the statement.

If you receive a refund of interest you overpaid in an earlier year, this amount will be reported in box 3 of Form 1098. You cannot deduct this amount. For information on how to report this refund, see Refunds of interest later in this chapter.

Certain expenses you pay to obtain a mortgage cannot be deducted as interest. These expenses, which include mortgage commissions, abstract fees, and recording fees, are capital expenses. If the property mortgaged is business or income-producing property, you can amortize the costs over the life of the mortgage.

If you pay off your mortgage early and pay the lender a penalty for doing this, you can deduct the penalty as interest.

Interest charged on employment taxes assessed on your business is deductible.

OID is a form of interest. A loan (mortgage or other debt) generally has OID when its proceeds are less than its principal amount. The OID is the difference between the stated redemption price at maturity and the issue price of the loan.

A loan's stated redemption price at maturity is the sum of all amounts (principal and interest) payable on it other than qualified stated interest. Qualified stated interest is stated interest that is unconditionally payable in cash or property (other than another loan of the issuer) at least annually over the term of the loan at a single fixed rate.

The OID is de minimis if it is less than one-fourth of 1% (.0025) of the stated redemption price of the loan at maturity multiplied by the number of full years from the date of original issue to maturity (the term of the loan).

If the OID is de minimis, you can choose one of the following ways to figure the amount you can deduct each year.

You make this choice by deducting the OID in a manner consistent with the method chosen on your timely filed tax return for the tax year in which the loan is issued.

If the OID is not de minimis, you must use the constant-yield method to figure how much you can deduct each year. You figure your deduction for the first year using the following steps.

To figure your deduction in any subsequent year, follow the above steps, except determine the adjusted issue price in step (1). To get the adjusted issue price, add to the issue price any OID previously deducted. Then follow steps (2) and (3) above.

The yield to maturity is generally shown in the literature you receive from your lender. If you do not have this information, consult your lender or tax advisor. In general, the yield to maturity is the discount rate that, when used in computing the present value of all principal and interest payments, produces an amount equal to the principal amount of the loan.

If your loan or mortgage ends, you may be able to deduct any remaining OID in the tax year in which the loan or mortgage ends. A loan or mortgage may end due to a refinancing, prepayment, foreclosure, or similar event.

The term “points” is often used to describe some of the charges paid by a borrower when the borrower takes out a loan or a mortgage. These charges are also called loan origination fees, maximum loan charges, or premium charges. If any of these charges (points) are solely for the use of money, they are interest.

Because points are prepaid interest, you cannot deduct the full amount in the year paid. (For an exception for points paid on your home mortgage, see Publication 936.) Instead, the points reduce the issue price of the loan and result in original issue discount, deductible as explained in the preceding discussion.

If you make partial payments on a debt (other than a debt owed the IRS), the payments are applied, in general, first to interest and any remainder to principal. You can deduct only the interest. This rule does not apply when it can be inferred that the borrower and lender understood that a different allocation of the payments would be made.

If you make an installment purchase of business property, the contract between you and the seller generally provides for the payment of interest. If no interest or a low rate of interest is charged under the contract, a portion of the stated principal amount payable under the contract may be recharacterized as interest (unstated interest). The amount recharacterized as interest reduces your basis in the property and increases your interest expense. For more information on installment sales and unstated interest, see Publication 537.

If you use the cash method of accounting, you cannot deduct interest you pay with funds borrowed from the original lender through a second loan, an advance, or any other arrangement similar to a loan. You can deduct the interest expense once you start making payments on the new loan.

When you make a payment on the new loan, you first apply the payment to interest and then to the principal. All amounts you apply to the interest on the first loan are deductible, along with any interest you pay on the second loan, subject to any limits that apply.

You cannot currently deduct interest you are required to capitalize under the uniform capitalization rules. See Capitalization of Interest, later. In addition, if you buy property and pay interest owed by the seller (for example, by assuming the debt and any interest accrued on the property), you cannot deduct the interest. Add this interest to the basis of the property.

Fees you incur to have business funds available on a standby basis, but not for the actual use of the funds, are not deductible as interest payments. You may be able to deduct them as business expenses.

If the funds are for inventory or certain property used in your business, the fees are indirect costs and you generally must capitalize them under the uniform capitalization rules. See Capitalization of Interest, later.

Interest charged on income tax assessed on your individual income tax return is not a business deduction even though the tax due is related to income from your trade or business. Treat this interest as a business deduction only in figuring a net operating loss deduction.

Penalties on underpaid deficiencies and underpaid estimated tax are not interest. You cannot deduct them. Generally, you cannot deduct any fines or penalties.

You generally cannot deduct interest on a debt incurred with respect to any life insurance, annuity, or endowment contract that covers any individual unless that individual is a key person.

If the policy or contract covers a key person, you can deduct the interest on up to $50,000 of debt for that person. However, the deduction for any month cannot be more than the interest figured using Moody's Corporate Bond Yield Average-Monthly Average Corporates (Moody's rate) for that month.

A key person is an officer or 20% owner. However, the number of individuals you can treat as key persons is limited to the greater of the following.

You can generally deduct the interest if the contract was issued before June 9, 1997, and the covered individual is someone other than an employee, officer, or someone financially interested in your business. If the contract was purchased before June 21, 1986, you can generally deduct the interest no matter who is covered by the contract.

Corporations and partnerships generally cannot deduct any interest expense allocable to unborrowed cash values of life insurance, annuity, or endowment contracts. This rule applies to contracts issued after June 8, 1997, that cover someone other than an officer, director, employee, or 20% owner. For more information, see section 264(f) of the Internal Revenue Code.

You produce property if you construct, build, install, manufacture, develop, improve, create, raise, or grow it. Treat property produced for you under a contract as produced by you up to the amount you pay or incur for the property.

Carrying charges include taxes you pay to carry or develop real estate or to carry, transport, or install personal property. You can choose to capitalize carrying charges not subject to the uniform capitalization rules if they are otherwise deductible. For more information, see chapter 8.

Treat capitalized interest as a cost of the property produced. You recover your interest when you sell or use the property. If the property is inventory, recover capitalized interest through cost of goods sold. If the property is used in your trade or business, recover capitalized interest through an adjustment to basis, depreciation, amortization, or other method.

The interest capitalization rules are applied first at the partnership or S corporation level. The rules are then applied at the partners' or shareholders' level to the extent the partnership or S corporation has insufficient debt to support the production or construction costs.

If you are a partner or a shareholder, you may have to capitalize interest you incur during the tax year for the production costs of the partnership or S corporation. You may also have to capitalize interest incurred by the partnership or S corporation for your own production costs. To properly capitalize interest under these rules, you must be given the required information in an attachment to the Schedule K-1 you receive from the partnership or S corporation.

The procedures for applying the uniform capitalization rules are beyond the scope of this publication. For more information, see sections 1.263A–8 through 1.263A–15 of the regulations and Notice 88–99. Notice 88–99 is in Cumulative Bulletin 1988–2.

Under the cash method, you can generally deduct only the interest you actually paid during the tax year. You cannot deduct a promissory note you gave as payment because it is a promise to pay and not an actual payment.

You generally cannot deduct any interest paid before the year it is due. Interest paid in advance can be deducted only in the tax year in which it is due.

If interest or a discount is subtracted from your loan proceeds, it is not a payment of interest and you cannot deduct it when you get the loan. For more information, see Original issue discount (OID) under Interest You Can Deduct, earlier.

If you pay interest and then receive a refund in the same tax year of any part of the interest, reduce your interest deduction by the refund. If you receive the refund in a later tax year, include the refund in your income to the extent the deduction for the interest reduced your tax.

Under an accrual method, you can deduct only interest that has accrued during the tax year.

You generally cannot deduct any interest paid before it is due. Instead, deduct it in the year in which it is due.

If interest or a discount is subtracted from your loan proceeds, it is not a payment of interest and you cannot deduct it when you get the loan. For more information, see Original issue discount (OID) under Interest You Can Deduct, earlier.

If you contest a federal income tax deficiency, interest does not accrue until the tax year the final determination of liability is made. If you do not contest the deficiency, then the interest accrues in the year the tax was asserted and agreed to by you.

However, if you contest but pay the proposed tax deficiency and interest, and you do not designate the payment as a cash bond, then the interest is deductible in the year paid.

If you use an accrual method, you cannot deduct interest owed to a related person who uses the cash method until payment is made and the interest is includible in the gross income of that person. The relationship is determined as of the end of the tax year for which the interest would otherwise be deductible. If a deduction is denied under this rule, the rule will continue to apply even if your relationship with the person ceases to exist before the interest is includible in the gross income of that person. See Related Persons in Publication 538.

The rules for below-market loans apply to the following.

Except as noted in (5) above, these rules apply to demand loans (loans payable in full at any time upon the lender's demand) outstanding after June 6, 1984, and to term loans (loans that are not demand loans) made after that date.

If you receive a below-market gift loan or demand loan, you are treated as receiving an additional payment (as a gift, dividend, etc.) equal to the forgone interest on the loan. You are then treated as transferring this amount back to the lender as interest. These transfers are considered to occur annually, generally on December 31. If you use the loan proceeds in your trade or business, you can deduct the forgone interest each year as a business interest expense. The lender must report it as interest income.

For gift loans between individuals, forgone interest treated as transferred back to the lender is limited to the borrower's net investment income for the year. This limit applies if the outstanding loans between the lender and borrower total $100,000 or less. If the borrower's net investment income is $1,000 or less, it is treated as zero. This limit does not apply to a loan if the avoidance of any federal tax is one of the main purposes of the interest arrangement.

If you receive a below-market term loan other than a gift or demand loan, you are treated as receiving an additional cash payment (as a dividend, etc.) on the date the loan is made. This payment is equal to the loan amount minus the present value, at the applicable federal rate, of all payments due under the loan. The same amount is treated as original issue discount on the loan. See Original issue discount (OID) under Interest You Can Deduct, earlier.

The rules for below-market loans do not apply to any day on which the total outstanding loans between the borrower and lender is $10,000 or less. This exception applies only to the following.

This exception does not apply to a term loan described in (2) above that was previously subject to the below-market loan rules. Those rules will continue to apply even if the outstanding balance is reduced to $10,000 or less.

The following loans are specifically exempted from the rules for below-market loans because their interest arrangements do not have a significant effect on the federal tax liability of the borrower or the lender.

The below-market interest rules do not apply to a loan made to a qualified continuing care facility under a continuing care contract if the lender (or lender's spouse) is age 65 or older by the end of the calendar year. For 2003, this exception applies only to the part of the total outstanding loans from the lender (or lender's spouse) that does not exceed $151,000.

Different rules generally apply to a loan connected with the sale or exchange of property. If the loan does not provide adequate stated interest, part of the principal payment may be considered interest. However, there are exceptions that may require you to apply the below-market interest rate rules to these loans. See Unstated Interest and Original Issue Discount (OID) in Publication 537.

For more information on below-market loans, see section 7872 of the Internal Revenue Code and section 1.7872–5T of the regulations.