The information below is intended to explain in general the income tax issues of a debt-financed distribution from a partnership and the corresponding interest expense.

A debt-financed distribution occurs when a partnership borrows funds and then distributes a portion of those funds to its partners. The distributed loan proceeds and related interest expense must be separately reported to the partners because of certain special tax issues associated with the debt-financed distribution. For income tax purposes, the deductibility of the interest expense depends upon how the partner uses the debt-financed distribution. For example:

1. If debt proceeds are used for personal purposes, the interest expense is not deductible.

2. If debt proceeds are used in passive activities, the interest expense may be deductible but is subject to passive activity loss limitation rules.

3. If debt proceeds are used in investment activities, the interest expense is treated as investment interest expense and is potentially deductible as an itemized deduction on Schedule A.

4. If debt proceeds are used in non-passive trade or business activities, the interest expense is deductible in computing the net income or loss of the trade or business.

Obviously, the best tax answer would result if the refinanced debt is traced to #2, #3 or #4 above and as little traced to #1 above.

The problem with the debt-financed distribution tax rules is tracing how the debt proceeds were used. The IRS has issued Notice 89-35 as guidance on this issue for debt-financed distributions from partnerships. IRS Notice 89-35 offers an election to partnerships to allow the partnership to allocate the debt refinancing to all of its own expenditures rather than distributions. Therefore, if a partnership had a $1,400,000 of excess refinancing that was distributed to its partners, but also had $500,000 of other cash expenses paid by rental receipts, then the partnership could elect to treat $500,000 of the debt refinancing as being used to pay the $500,000 of rental expenses. By doing so, $500,000 of the excess refinanced debt would be considered good debt and the interest deductible by the partnership. The interest on the other $900,000 would be only be deductible depending upon how the partners used $900,000 of the distributions.

Please note that in the above example the $500,000 of operating expenses is still deductible even if the optional Notice 89-35 is made. The election only affects the character of the interest expense and does not affect the tax deductibility of the operating expenses.

Obviously, this information is not intended to be all-encompassing with respect to the legal, economic or tax considerations involved and should not be relied upon for such matters.