8043 / How is interest traced to personal, investment, and passive activity expenditures?

Generally, the interest tracing rules allocate debt and the interest on it to expenditures according to the use of the debt proceeds. The deductibility of the interest is generally determined by the expenditure to which it is allocated. The allocation of interest under these rules is unaffected by the use of any asset or property to secure the debt; for example, interest on a debt traced to the purchase of an automobile will be personal interest even though the debt may be secured by shares of stock.¹

Specific Ordering Rules

The tracing of debt proceeds is accomplished by specific rules that determine the order in which amounts borrowed are used. The allocation of debt under these specific ordering rules depends on the manner in which the debt proceeds are distributed to and held by the borrower. The following alternatives and results are described in regulations:

(1) Proceeds are deposited in borrower’s account that also contains unborrowed funds: The first expenditures made from the account (with two exceptions) will be treated as made from the debt proceeds to the extent thereof. If proceeds from more than one debt are deposited, the funds will be considered expended in the order in which they were deposited. If they were deposited simultaneously, they will be treated as deposited in the order in which the debts were incurred.²

Exceptions to this rule are: (a) any expenditure made from an account within the 30 days before or after the debt proceeds are deposited may be treated as made from the debt proceeds (to the extent thereof); and (b) if an account consists solely of debt proceeds and interest income on those proceeds, any expenditures from the account may be treated as first from the interest income, to the extent thereof at the time of the expenditure.³