The Mechanics of Debt-Financed Distributions in Real Estate

Summary: Refinancing appreciated real estate allows pass-through entities and owners to distribute cash, but the deductibility of interest expense depends on how proceeds are allocated and used. Failure to follow IRS rules when distributing proceeds after refinancing or acquiring debt may result in limited interest expense deductions for business owners.

Real estate continues to be a cornerstone of wealth accumulation, and for owners of pass-through entities, making strategic decisions about equity has never been more crucial. Within the ever-evolving real estate market, rising property values can make cashing out on property appreciation an attractive option for property owners. While selling may seem like the obvious path, there are several options businesses and their owners can take advantage of, one of the most powerful being debt-financed distributions.

What are Debt-Financed Distributions?

Debt-financed distributions occur when debt is either acquired or refinanced, and the proceeds are distributed to the owners. This approach lets owners access the built-up equity from their appreciated property without immediately triggering taxable gain, since the distribution itself isn’t considered a taxable event. This concept is particularly important in relation to partnerships and S corporations, where the owners may receive distributions funded by entity-level debt. While the strategy can provide liquidity and preserve ownership, it also carries important tax considerations, particularly regarding whether the interest on borrowed funds is deductible.

Interest Allocation Methods: Tracing vs. Optional

A common misconception is that related interest to debt-financed distributions is automatically a deductible expense. However, allocation and how those proceeds are used by the owners after being distributed plays a critical role in determining the deductibility of the interest expense. To clarify the rules on deductibility, the IRS introduced two primary allocation methods for debt proceeds and associated interest expense.

The Tracing Method

Under the tracing method, also referred to as the general allocation rule, recipients must track how they use the distributed funds. The deductibility of interest isn’t determined by the nature of the distribution or the source of the loan that governs deductibility, but rather by the ultimate use of the proceeds. These uses fall into two main categories: personal use or income producing activities and investments. Once the category is determined, the related interest expense assumes the same character of the expenditure.

There are several possible outcomes related to interest deductibility under the tracing rules, such as:

• If the funds were used for expenses of a personal nature, the related interest expense will also be considered personal, making it not deductible. 
• If the proceeds were used in nonpassive trade or business activities, the related interest expense is deductible when computing income or loss.
• When proceeds are used in a passive activity, the related interest is subject to the passive activity loss limitation rules, requiring further analysis to determine deductibility.
• If used for investment activities, the interest may be treated as investment interest expense, potentially qualifying for a deduction on Schedule A of the owner’s 1040.

Since tracing rules play a key role in interest deductibility for the recipients, it’s critical to emphasize the importance of proper documentation and careful planning to optimize tax outcomes in debt-financed distribution scenarios. Failure to do so can result in disallowed interest deductions and IRS scrutiny. 

The Optional Method

The optional allocate method, allows owners to allocate the distributed debt proceeds and related interest expense to one or more expenditures made during the same taxable year as the distribution. If expenditures exceed the distributions, and no other debt has already been allocated to them, owners may avoid debt-financed distribution limitations.

However, if in the taxable year those expenditures already have debt allocated to them, they are not eligible expenditures. Additionally, if the loan proceeds exceed the amount of identifiable expenditures to which they could be allocated, the excess proceeds must be allocated according to the general tracing rules. While the optional allocation rule may appear more flexible, it carries its own set of restrictions that must be carefully considered.

Final Thoughts: Proceed with Purpose

Debt-financed distributions can serve as a powerful tool for unlocking liquidity to owners without triggering immediate income recognition, but they also introduce a layer of complexity that should not be overlooked. Both allocation methods place the burden on taxpayers to clearly document the allocation and use of the proceeds. By approaching these transactions with intention, proactive planning, and consistent documentation, businesses and their owners can take advantage of the benefits, while minimizing the risk of unexpected tax consequences.