rr-08-38.pdf

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Part I

Section 702.—Income and Credits of a Partner

26 CFR: (None)
(Also: 62, 163)

Rev. Rul. 2008-38

ISSUES
(1) In the case of an individual, is interest paid or accrued on indebtedness allocable to
property described in § 163(d)(5)(A)(ii) of the Internal Revenue Code deductible (after
the application of the § 163(d)(1) limitation) in determining the taxpayer’s adjusted gross
income or does the interest (after the application of the § 163(d)(1) limitation) instead
constitute an itemized deduction?
(2) If an individual has both investment interest expense attributable to indebtedness
allocable to property described in § 163(d)(5)(A)(ii) and investment interest expense
attributable to indebtedness allocable to property described in § 163(d)(5)(A)(i) and the
individual’s aggregate investment interest expense is greater than the individual’s net
investment income, how does the individual determine the portion of the allowed

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investment interest deduction that is deductible in determining the taxpayer’s adjusted
gross income and the portion that constitutes an itemized deduction?
FACTS
Situation 1

PRS is a partnership that is engaged solely in the trade or business of trading
securities for its own account and not for customers. LP, an individual, owns an interest
in PRS as a limited partner. LP does not materially participate (as that term is used in
§ 469) in the activity in which PRS is engaged. The taxable year for PRS and LP is the
calendar year.
PRS incurs indebtedness in its trade or business of trading securities. In Year 1,
LP’s distributive share of PRS’ income, gain, loss, deduction, and credit includes $200x
of interest expense incurred by PRS with respect to its indebtedness. LP’s net
investment income, as defined in § 163(d)(4), for Year 1 is equal to $150x. During Year
1, LP’s distributive share of PRS’ interest expense is the only interest paid or accrued
by LP (either directly or through any flow-through entity) on indebtedness properly
allocable to property held for investment (as defined in § 163(d)(5)(A)). LP’s distributive
share of PRS’ interest expense is not subject to any limitation under § 465 or 704(d).
Situation 2

The facts are the same as in Situation 1 except that during Year 1 LP also pays
$100x of interest expense on indebtedness properly allocable to stocks and bonds held
by LP for investment (within the meaning of § 163(d)(5)(A)(i)). None of the $100x of
interest expense is described in § 265(a).

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LAW AND ANALYSIS
Section 62(a) provides that the term “adjusted gross income” means, in the case
of an individual taxpayer, gross income minus the deductions specified in § 62(a)(1)
through (21).
Section 62(a)(1) provides that deductions allowed by chapter 1 of subtitle A,
other than by part VII of subchapter B, which are attributable to a trade or business
carried on by the taxpayer, if such trade or business does not consist of the
performance of services by the taxpayer as an employee, are taken into account in
determining the adjusted gross income of the taxpayer.
Section 63(d) defines the term “itemized deductions” as including all deductions
allowable under chapter 1 of subtitle A other than deductions allowable in arriving at
adjusted gross income and the deduction for personal exemptions provided in § 151.
Section 163(d)(1) provides that, in the case of a noncorporate taxpayer, the
amount allowed as a deduction under chapter 1 of subtitle A for investment interest for
any taxable year shall not exceed the amount of the taxpayer’s net investment income
for the taxable year. Section 163(d)(2) provides that any amount not allowed as a
deduction for a given taxable year by reason of § 163(d)(1) shall be treated as
investment interest paid or accrued by the taxpayer in the next succeeding taxable year.
Section 163(d)(3)(A) provides that the term “investment interest” means any
interest allowable as a deduction under chapter 1 of subtitle A (determined without
regard to paragraph (1) of § 163(d)) which is paid or accrued on indebtedness properly
allocable to property held for investment.

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Section 702(a)(8) provides that, in determining the partner’s income tax, each
partner shall take into account the partner’s distributive share of the partnership’s
taxable income or loss, exclusive of the items requiring separate computation under
§ 702(a)(1) through (7). Section 702(a)(1) through (6) lists specific items of income,
gain, loss, deduction or credit that must be separately stated by a partnership. Section
702(a)(7) provides that other items of income, gain, loss, deduction or credit also must
be separately stated if required by regulations prescribed by the Secretary.
Section 702(b) provides that the character of any item of income, gain, loss,
deduction, or credit included in a partner’s distributive share under paragraphs (1)
through (7) of § 702(a) shall be determined as if such item were realized directly from
the source from which realized by the partnership, or incurred in the same manner as
incurred by the partnership.
Section § 1.702-1(a)(8)(ii) of the Income Tax Regulations provides that each
partner must take into account separately the partner’s distributive share of any
partnership item that, if separately taken into account by the partner, would result in an
income tax liability for that partner, or for any other person, different from that which
would result if that partner did not take the item into account separately.
Section 706(a) provides that, in computing the taxable income of a partner for a
taxable year, the inclusions required by § 702 and § 707(c) with respect to a partnership
shall be based on the income, gain, loss, deduction, or credit of the partnership for any
taxable year of the partnership ending within or with the taxable year of the partner.

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Revenue Ruling 2008-12, 2008-10 IRB 520, holds that, by virtue of the definition
of the term “property held for investment” in § 163(d)(5)(A)(ii), a noncorporate limited
partner’s distributive share of interest expense on indebtedness allocable to a
partnership’s trade or business of trading securities for its own account constitutes
investment interest described in § 163(d)(3) and is therefore subject to the limitation on
the deduction of investment interest in § 163(d)(1), provided that the limited partner
does not materially participate (as that term is used in § 469) in the trading activity. The
ruling further holds that a partnership that engages in the trade or business of trading
securities for its own account must separately state the amount of interest paid or
accrued on indebtedness properly allocable to its trading activity because the degree of
participation by each noncorporate partner of the partnership could limit the deductibility
of such interest by the partner on his or her individual tax return.
Situation 1

LP’s only investment interest (as defined in § 163(d)(3)) for Year 1 is LP’s $200x
distributive share of PRS’ interest expense in Year 1. This investment interest is subject
to the limitation on investment interest in § 163(d)(1). Section 163(d)(1) limits LP’s
deduction for investment interest in Year 1 to $150x, the amount of LP’s net investment
income (as defined in § 163(d)(4)) for that year. Accordingly, in Year 1, LP may deduct
$150x of LP’s $200x distributive share of the interest expense of PRS. Pursuant to
§ 163(d)(2), the $50x of interest expense not allowed as a deduction for Year 1 is
treated as investment interest paid or accrued in Year 2.

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LP’s distributive share of PRS’ Year 1 interest expense that is allowed under
§ 163(d)(1) is deductible in arriving at LP’s adjusted gross income pursuant to
§ 62(a)(1). Section 702(b) provides that the character of any item of deduction included
in a partner’s distributive share under § 702(a) shall generally be determined as if such
item were incurred in the same manner as incurred by the partnership. Because the
interest expense of PRS is attributable to the carrying on of its trade or business of
trading securities, LP’s share of that expense is described in § 62(a)(1). While LP’s
distributive share of PRS’ interest expense is subject to the investment interest limitation
in § 163(d)(1), the investment interest limitation does not affect the character of the
interest expense for other purposes of the Code. Thus, except for purposes of applying
the investment interest limitation, LP’s distributive share of PRS’ interest expense
deductions are characterized under § 702(b).
Accordingly, $150x of LP’s distributive share of the Year 1 interest expense of
PRS is deductible in arriving at LP’s adjusted gross income. Therefore, such amount
does not constitute an itemized deduction (as defined in § 63(d)).
Situation 2

In Situation 2, in addition to LP’s $200x distributive share of PRS’ Year 1 interest
expense, LP also pays $100x of interest expense on indebtedness properly allocable to
stocks and bonds held by LP for investment (within the meaning of § 163(d)(5)(A)(i)).
Accordingly, LP’s total investment interest expense for Year 1 is $300x. Pursuant to
§ 163(d)(1), LP is allowed to deduct only $150x of this investment interest expense in
Year 1.

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To the extent that LP’s $150x of allowed investment interest deduction is
attributable to indebtedness incurred in PRS’ trade or business of trading securities, the
deduction is taken into account in arriving at LP’s adjusted gross income. To the extent
the $150x of allowed investment interest deduction is attributable to the indebtedness
attributable to the stock and bonds held for investment, the deduction is not taken into
account in arriving at LP’s adjusted gross income and is instead reported as an itemized
deduction.
When an individual has both investment interest expense attributable to property
described in § 163(d)(5)(A)(i) and investment interest expense attributable to property
described in § 163(d)(5)(A)(ii) and the individual’s aggregate investment interest
expense is greater than the individual’s net investment income, the individual must
allocate the taxpayer’s net investment income to the two categories of investment
interest expenses using a reasonable method of allocation. One reasonable method is
to allocate the net investment income to the two categories of investment interest in the
same proportion that the amount of investment interest in each category bears to the
total amount of investment interest (the pro rata method). In Situation 2, two-thirds
($200x/$300x) of LP’s aggregate investment interest expense is attributable to LP’s
interest in the trade or business of trading securities of PRS (property described in
§ 163(d)(5)(A)(ii)), and one-third ($100x/$300x) is attributable to stocks and bonds held
by LP for investment (property described in § 163(d)(5)(A)(i)). Accordingly, using a pro
rata method, two-thirds of LP’s $150x of net investment income is allocated to LP’s
distributive share of the interest expense of PRS, while one-third of LP’s $150x of net

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investment income is allocated to LP’s other investment interest expense. Therefore,
using this method of allocation, of LP’s allowed $150x investment interest deduction in
Year 1 under § 163(d)(1), $100x is taken into account in arriving at LP’s adjusted gross
income under § 62(a), while the remaining $50x constitutes an itemized deduction
under § 63(d). The $150x of investment interest that is not allowed as a deduction
under § 163(d)(1) in Year 1 is treated as investment interest paid or accrued in Year 2
pursuant to § 163(d)(2). The $150x of investment interest that is not allowed as a
deduction under § 163(d)(1) in Year 1 is comprised of $100x of investment interest
attributable to LP’s interest in PRS’ trade or business (an interest described in
§ 163(d)(5)(A)(ii)) and $50x of investment interest expense attributable to stocks and
bonds held for investment (within the meaning of § 163(d)(5)(A)(i)).
HOLDINGS
Issue 1: In the case of an individual, interest paid or accrued on indebtedness
allocable to property held for investment described in § 163(d)(5)(A)(ii) is (after the
application of the § 163(d)(1) limitation) a deduction described in § 62(a)(1) and is
therefore taken into account in determining the individual’s adjusted gross income.
Issue 2: If an individual has both investment interest expense attributable to
indebtedness allocable to property described in § 163(d)(5)(A)(i) and investment interest
expense attributable to indebtedness allocable to property described in § 163(d)(5)(A)(ii)
and the individual’s aggregate investment interest expense is greater than the
individual’s net investment income, the individual must allocate the individual’s net
investment income between the two categories of investment interest expense using a

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reasonable method of allocation. One reasonable method of allocation is to allocate the
individual’s net investment income to the two categories of investment interest in
proportion to the relative amounts of interest expense within each category.
EFFECT ON OTHER REVENUE RULINGS
Rev. Rul. 2008-12 is amplified.
DRAFTING INFORMATION
The principal author of this revenue ruling is Faith P. Colson of the Office of
Associate Chief Counsel (Passthroughs & Special Industries). For further information
regarding this revenue ruling, contact Faith P. Colson at (202) 622-3060 (not a toll-free
call).