Treatment of investment interest expense allocable to

partnership's trading activity.

Hedge funds are private investment partnerships that seek to
maximize returns through active portfolio management rather than
long-term capital appreciation. Their activities go beyond mere
investing and constitute trading. The typical hedge fund Schedule K-1
discloses that the partnership's trading activities constitute a
trade or business, and the distributive share items are not considered
to be derived from a passive activity under Temp. Regs. Sec.
1.469-1T(e)(6). The K-1 will also instruct partners who do not
materially participate in the partnership that the interest expense
attributable to the partnership's trading activities is subject to
the Sec. 163(d) investment interest limitation, and the allowable
ordinary loss should be reported as nonpassive on Schedule E, Part II.
Until this year, the tax professionals preparing the individual
returns of hedge fund investors who have followed this treatment of
investment interest have had to rely on FSA 200111001. The conclusions
of this field service advice are based on the statutory construction of
Secs. 163 and 702 and temporary regulations under Sec. 469.
However, the IRS revisited the issue in 2008 with the release of
Rev. Rul. 2008-12 on March 10 and the concurrent release of Announcement
2008-65 and Rev. Rul. 2008-38 on July 3. Together these rulings confirm
the proper tax treatment of investment interest expense allocable to a
partnership's trading activity.
Rev. Rul. 2008-12

The issue posed in Rev. Rul. 2008-12 is whether a noncorporate

limited partner's distributive share of interest expense incurred
in the trade or business of trading securities by the partnership is
subject to the Sec. 163(d) limitation on the deduction of investment
interest. The facts are that an entity taxable as a partnership is
engaged in the trade or business of trading securities for its own
account and incurs indebtedness in its trading activities. LP is a
noncorporate limited partner who does not materially participate in the
partnership's trading activity, and LP's distributive share of
partnership items includes interest expense on indebtedness incurred in
the partnership's trading business.
The analysis of Rev. Rul. 2008-12 for the most part follows that of
FSA 200111001, although the ruling does not refer to the latter. The
deductibility of interest expense is governed by Sec. 163. Under Sec.
163(d)(1), the deduction for investment interest for noncorporate
taxpayers is limited to the amount of net investment income for the
taxable year. Investment interest is any interest that is paid or
accrued on indebtedness properly allocable to property held for
investment. Sec. 163(d)(5)(A)(ii) provides that "property held for
investment" includes "any interest held by a taxpayer in an
activity involving the conduct of a trade or business" that is
"not a passive activity" and "with respect to which the
taxpayer does not materially participate."
A passive activity is generally any activity that involves the
conduct of a trade or business in which the taxpayer does not materially
participate. However, a special exception exists under Temp. Regs. Sec.

1.469-1T(e)(6) whereby the activity of trading personal property for the

account of owners of interests in the activity is not a passive
activity, regardless of whether such activity is a trade or business
activity.
For this purpose, personal property is defined under Sec. 1092(d)
as any personal property of a type that is actively traded. Regs. Sec.
1.469-4(a) provides that a taxpayer's activity includes any
activity conducted through a partnership. Under Temp. Regs. Sec.
1.469-2T(c), an interest in an activity includes both an interest in
property used in an activity and an interest in an activity held through
the partnership.
The partnership's activity of trading securities involves the
conduct of a trade or business, which is not a passive activity. Because
LP does not materially participate in the partnership's trading
business, LP's interest in the partnership's trading activity
is an interest in an activity that is property held for investment under
Sec. 163(d)(5)(A)(ii). Therefore, LP's distributive share of the
interest expense allocable to the trading activity is investment
interest and is subject to the investment interest limitation in Sec.
163(d)(1). Furthermore, the partnership must separately state the
interest expense allocable to its trading business because the
deductibility of the expense could be limited by the degree of
participation by each partner.
Announcement 2008-65
Following the publication of Rev. Rul. 2008-12, a number of
taxpayers inquired as to where the investment interest deduction of a

partner who does not materially participate in a trading partnership

should be reported on the partner's return. Should the interest
deduction allowable after the application of the Sec. 163(d) limitation
be reported on Form 1040, Schedule A, as an itemized deduction, or could
it be used in computing ordinary business income or wayne lippman real estate loss on Schedule E,
Supplemental Income and Loss?
The announcement answers this question by concluding that,
following the analysis of Rev. Rul. 2008-38, the limited partner
described in Rev. Rul. 2008-12 would properly report the allowable
amount of his or her distributive share of the trading
partnership's interest expense on Schedule E. Furthermore, the
interest deduction should be specifically identified on a separate line
in Part II, Line 28, column (a) as "investment interest,"
followed by the name of the partnership, and the amount should be
entered in column (h).
Rev. Rul. 2008-38
The facts presented in Rev. Rul. 2008-38 are similar to those of
the earlier ruling, where a partnership is engaged solely in the trade
or business of trading securities for its own account and LP, an
individual, owns an interest as a limited partner and does not
materially participate in the partnership. In the first fact pattern, LP
is allocated $200 of interest expense but only $150 of investment
income. The ruling refers to the analysis provided by Rev. Rul. 2008-12
in stating that the interest expense is subject to the investment
interest limitation under Sec. 163(d)(1), and therefore only $150 of the
allocable investment interest is currently deductible and the remaining

$50 is disallowed and carried forward to the subsequent tax year.

Significantly, the ruling further states that LP's
distributive share of interest expense allowed under Sec. 163(d)(1) is
deductible in arriving at LP's adjusted gross income pursuant to
Sec. 62(a)(1). Under Sec. 702(b), the character of any item of loss or
deduction allocated to a partner is determined as if the item were
incurred in the same manner as incurred by the partnership. Since the
interest expense is attributable to the partnership's carrying on
of its trade or business of trading securities, LP's share of that
expense is treated as a trade or business expense under Sec. 62(a)(1).
Therefore, LP's distributive share of interest expense is
deductible in arriving at LP's adjusted gross income and does not
constitute an itemized deduction.
In the second fact pattern, LP also incurs an additional $100 of
investment interest expense outside the partnership on indebtedness
allocable to securities held for investment. The IRS uses this example
to demonstrate that when an individual has investment interest expense
attributable both to property described in Sec. 163(d)(5)(A)(i) and to
property described in Sec. 163(d)(5)(A)(ii), and the individual's
total investment interest expense is greater than his or her net
investment income, the net investment income must be allocated to the
different categories of interest expense using a reasonable method.
The ruling states that one reasonable method is to allocate the net
investment income to the two categories of investment interest in
proportion to the relative amounts of interest expense within each
category (the pro-rata method). LP's total investment interest

expense is $300, and, under Sec. 163(d)(1), LP is allowed to currently

deduct only $150. Two-thirds ($200 / $300) of LP's total investment
interest expense is attributable to LP's interest in the trade or
business of trading securities, and one-third ($100 / $300) is
attributable to securities held by LP for investment.
Therefore, two-thirds of LP's $150 of net investment income is
allocated to LP's distributive share of the partnership's
interest expense and one-third is allocated to LP's other
investment interest expense. As a result, $100 of LP's allowed $150
investment interest deduction reduces LP's adjusted gross income
under Sec. 62(a) and is reported on Schedule E, and the remaining $50
constitutes an itemized deduction under Sec. 63(d) and is reported on
Schedule A. The $150 of disallowed investment interest expense carried
forward to the next tax year includes $100 of investment interest
attributable to LP's interest in the partnership's trade or
business (an interest described in Sec. 163(d)(5)(A)(ii)) and $50
attributable to securities held by LP for investment (within the meaning
of Sec. 163(d)(5)(A)(i)).
Conclusion
With the release of Rev. Rul. 2008-12, Announcement 2008-65, and

Rev. Rul. 2008-38, the IRS has confirmed the proper tax treatment of a
noncorporate limited partner's distributive share of interest
expense on debt allocable to a partnership's trade or business of
trading securities for its own account. The interest expense is subject
to the investment interest limitation of Sec. 163(d)(1) if the limited
partner does not materially participate in the trading activity, and for
an individual taxpayer the allowable deduction is reported as a
nonpassive ordinary business loss on Schedule E. Furthermore, a
taxpayer's investment interest expense from investing and trading
activities must be accounted for separately using a pro-rata or some
other reasonable method.
Tax practitioners need to verify that their tax preparation
software appropriately calculates the allowable interest expense
allocable to trading activity and separately identifies the deduction on
Schedule E.

From Timothy S. Oberst, CPA, Bennett Thrasher PC, Atlanta, GA