Deduction Of Interest And Expenses

November 04, 2024

8030 / Can a partnership carry forward disallowed business interest?

<div class="Section1">The 2017 tax reform legislation created a special rule to allow partnerships to carry forward certain disallowed business interest deductions (the rule does not apply to S corporations or other pass-through entities, although the new law specifies that similar rules will apply). The general rules governing carrying forward disallowed business interest deductions (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>) do not apply to partnerships.<div class="Section1"> Instead, disallowed business interest deductions are allocated to each partner in the same manner as non-separately stated taxable income or loss of the partnership.<a href="#_ftn1" name="_ftnref1">1</a> The partner is entitled to deduct his or her share of excess business interest in any future year, but only: <blockquote>(1)  against excess taxable income (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>) attributed to the partner by the partnership, and (2)  when the excess taxable income is related to the activities that created the excess business interest carryforward.<a href="#_ftn2" name="_ftnref2">2</a></blockquote> Such a deduction also requires a corresponding reduction in excess taxable income. Further, if excess business interest is attributed to a partner, his or her basis in the partnership interest is reduced (not below zero) by the amount of the allocation even though the carryforward does not permit a partner’s deduction in the year of the basis reduction. The partner’s deduction in a future year for the carried forward interest will not require another basis adjustment. If the partner disposes of the partnership interest after a basis adjustment occurred, immediately before the disposition the partner’s basis will be increased by the amount that any basis reduction exceeds the amount of excess interest expense that has been deducted by the partner.<a href="#_ftn3" name="_ftnref3">3</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> for a discussion of the general rules governing the corporate deduction for business interest. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 163(j)(4). <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 163(j)(4)(B). <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 163(j)(4)(B)(iii). </div></div>

June 09, 2024

8029 / Is business interest deductible when the business is a pass-through entity?

<div class="Section1">Editor’s Note: The CARES Act modified the rules for calculating the business interest deduction in 2019 and 2020. For 2020, the 30 percent limit was increased to 50 percent (the 30 percent limit continued to apply to partnerships in 2019).<a href="#_ftn1" name="_ftnref1">1</a> All entities (corporations and pass-throughs) could elect to use 2019 ATI instead of 2020 ATI in determining the 2020 business interest expense deduction, which could increase the business interest deduction for businesses that experienced reduced income levels in 2020.<a href="#_ftn2" name="_ftnref2">2</a><div class="Section1"> Under the CARES Act, partnerships could elect to apply modified rules. Under the CARES Act Section 163(j)(10)(A)(ii) amendments, a partner could elect to treat 50 percent of its allocable share of a partnership’s excess business interest expense (EBIE) for 2019 as an interest deduction in the partner’s first tax year beginning in 2020 without limit. The remaining 50 percent of EBIE remained subject to the Section 163(j) limitation applicable to EBIE carried forward at the partner level (discussed below). Partners could elect out of the rule. See heading below for details.<a href="#_ftn3" name="_ftnref3">3</a> Businesses that operate as pass-through entities (partnerships, S corporations, sole proprietorships) are permitted to deduct interest expenses incurred in operating the business. The 2017 Tax Act generally limits the interest expense deduction to the sum of (1) business interest income, (2) 30 percent of the business’ adjusted taxable income and (3) floor plan financing interest.<a href="#_ftn4" name="_ftnref4">4</a> Businesses with average annual gross receipts of $25 million ($31 million for 2025; $30 million in 2024) or less for the three-taxable year period that ends with the previous tax year are exempt from this new limitation (i.e., businesses that meet the gross receipts test of IRC Section 448(c)).<a href="#_ftn5" name="_ftnref5">5</a> These rules are applied at the partnership level, and the deduction for business interest must be taken into account in determining the non-separately stated taxable income or loss of the partnership.<a href="#_ftn6" name="_ftnref6">6</a> Under the 2017 tax reform legislation, the limit on the amount that is allowed as a deduction for business interest is increased by a partner’s distributive share of the partnership’s excess taxable income.<a href="#_ftn7" name="_ftnref7">7</a> “Excess taxable income” is the amount that bears the same ratio to the partnership’s adjusted taxable income as: <blockquote>(x) the excess (if any) of (1) 30 percent of the adjusted taxable income of the partnership over (2) the amount (if any) by which the business interest of the partnership, reduced by floor plan financing interest, exceeds the business interest income of the partnership bears to (y) 30 percent of the adjusted taxable income of the partnership.<a href="#_ftn8" name="_ftnref8">8</a></blockquote> Excess taxable income must be allocated in the same manner as non-separately stated income and loss. A partner’s adjusted basis in his or her partnership interest must be reduced (not below zero) by the excess business interest that is allocated to the partner. The 2017 tax reform law provides that similar rules will apply to S corporations and their shareholders.<a href="#_ftn9" name="_ftnref9">9</a> As expressed in the Senate amendment to the 2017 tax reform legislation, the intent of this calculation was to allow a partner to deduct additional interest expense that the partner may have paid to the extent that the partnership could have deducted more business interest. “Business interest” means interest paid on indebtedness that is properly allocated to a trade or business but excluding investment interest.<a href="#_ftn10" name="_ftnref10">10</a> “Business interest income” means the amount of interest income that is included in the entity’s income and properly allocated to a trade or business, excluding investment interest income.<a href="#_ftn11" name="_ftnref11">11</a> “Trade or business” specifically excludes the trade or business of being an employee, any electing real property trades or businesses, electing farming businesses, furnishing or selling electrical, water or sewage disposal services, and gas or steam distribution and transportation.<a href="#_ftn12" name="_ftnref12">12</a> Electing real estate businesses and farming businesses are permitted to elect out of the Section 163(j) limitation, but are then generally ineligible for increased bonus depreciation. Under the CARES Act, businesses that elected out of the Section 163(j) limit could revoke that election to take advantage of bonus depreciation, which may be valuable now that the so-called “retail glitch” was fixed by the CARES Act. The business revoked the election by filing an amended tax return or administrative adjustment request (AAR).<a href="#_ftn13" name="_ftnref13">13</a> “Adjusted taxable income” for purposes of these rules means taxable income computed without regard to non-business items of income, gain deduction and loss, business interest and business interest income, the net operating loss deduction under Section 172, the deduction for pass-through entities under IRC Section 199A and any deductions for depreciation, amortization or depletion.<a href="#_ftn14" name="_ftnref14">14</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> for a discussion of the rules governing carryforwards of disallowed partnership business interest. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> for a discussion of the general rules governing the corporate deduction for business interest. CARES Act Elections The IRS gave businesses substantial flexibility in making and revoking elections related to business interest expense deduction under the CARES Act. A taxpayer could simply elect under Section 163(j)(10)(A)(iii) not to apply the 50 percent ATI limitation for the 2019 or 2020 tax year (2020 only for partnerships). An eligible taxpayer made the election not to apply the 50 percent ATI limitation by timely filing a federal income tax return or Form 1065 (or amendments) using the 30 percent ATI limitation. No formal statement was required. The taxpayer could then later revoke that election by filing an amended return or form using the 30 percent limit. Similarly, to use 2019 ATI for 2020, the taxpayer merely filed using 2019 ATI (and could then later revoke that election by filing a timely amended return or form). The election was made at the partnership level.<a href="#_ftn15" name="_ftnref15">15</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 163(j)(10)(A)(ii). <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 163(j)(10)(B). <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 163(j)(10)(A)(ii)(II). <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 163(j)(1). <a href="#_ftnref5" name="_ftn5">5</a>.  IRC §§ 163(j)(2), 448(c). <a href="#_ftnref6" name="_ftn6">6</a>.  IRC § 163(j)(4). <a href="#_ftnref7" name="_ftn7">7</a>.  IRC § 163(j)(4)(A)(ii)(II). <a href="#_ftnref8" name="_ftn8">8</a>.  IRC § 163(j)(4)(C). <a href="#_ftnref9" name="_ftn9">9</a>.  IRC § 163(j)(4)(D). <a href="#_ftnref10" name="_ftn10">10</a>.  IRC § 163(j)(5). <a href="#_ftnref11" name="_ftn11">11</a>.  IRC § 163(j)(6). <a href="#_ftnref12" name="_ftn12">12</a>.  IRC § 163(j)(7). <a href="#_ftnref13" name="_ftn13">13</a>.  Rev. Proc. 2020-22. <a href="#_ftnref14" name="_ftn14">14</a>.  IRC § 163(j)(8). <a href="#_ftnref15" name="_ftn15">15</a>.  Rev. Proc. 2020-22. </div></div>

June 09, 2024

8028 / Is business interest deductible when the business is a corporation?

<div class="Section1">Editor’s Note: The CARES Act increased the 30 percent limit, discussed below, to 50 percent for tax years beginning in 2019 and 2020.<a href="#_ftn1" name="_ftnref1">1</a> All entities (corporations and pass-throughs) could elect to use 2019 ATI instead of 2020 ATI in determining the 2020 business interest expense deduction, which could increase the business interest deduction for businesses who experienced reduced income levels in 2020.<a href="#_ftn2" name="_ftnref2">2</a> See heading below for information about making and revoking the election.</div> <div class="Section1"> Under pre-2018 law, business owners were typically permitted to deduct interest expenses incurred in carrying on a trade or business (subject to limitations).<a href="#_ftn3" name="_ftnref3">3</a> The 2017 tax reform legislation generally limits the interest expense deduction to the sum of (1) business interest income, (2) 30 percent of the business’ adjusted taxable income (ATI) and (3) floor plan financing interest (see below).<a href="#_ftn4" name="_ftnref4">4</a> Businesses with average annual gross receipts of $31 million or less (as indexed for 2025; $30 million for 2024) for the three-taxable year period that ends with the previous tax year are exempt from this new limitation (i.e., businesses that meet the gross receipts test of IRC Section 448(c)).<a href="#_ftn5" name="_ftnref5">5</a> Generally, the limit applies at the taxpayer level, but in the case of a group of affiliated corporations that file a consolidated return, it applies at the consolidated tax return filing level. “Business interest” generally excludes investment interest. It includes any interest paid or accrued on indebtedness properly allocable to carrying on a trade or business. “Business interest income” means the amount of interest that is included in the taxpayer’s gross income for the tax year that is properly allocable to carrying on a trade or business. “Adjusted taxable income” means taxable income computed without regard to (1) items of income, gain, deduction or loss not allocable to carrying on a trade or business, (2) business interest or business interest income, (3) any net operating loss deduction (NOL), (4) the deduction for pass-through income under Section 199A and (5) for years before 2022, any deduction for depreciation, amortization or depletion.<a href="#_ftn6" name="_ftnref6">6</a> For the purpose of the business interest deduction, adjusted taxable income was computed without regard to the deductions that are allowed for depreciation, amortization or depletion for tax years beginning after December 31, 2017 and before January 1, 2022. “Floor plan financing interest” is interest paid or accrued on floor plan financing indebtedness, which is indebtedness incurred to finance the purchase of motor vehicles held for sale or lease to retail customers (and secured by the inventory that is acquired).<a href="#_ftn7" name="_ftnref7">7</a> As a result of these rules, business interest income and floor plan financing interest are fully deductible, with the limitation applying to 30 percent of the business’ adjusted taxable income. Unused interest expense deductions may be carried forward indefinitely.<a href="#_ftn8" name="_ftnref8">8</a> CARES Act Elections The IRS gave businesses substantial flexibility in making and revoking elections related to business interest expense deduction under the CARES Act. A taxpayer could elect under Section 163(j)(10)(A)(iii) not to apply the 50 percent ATI limitation for a 2019 or 2020 taxable year (2020 only for partnerships). A taxpayer permitted to make the election made the election not to apply the 50 percent ATI limitation by timely filing a federal income tax return or Form 1065 (or amendments) using the 30 percent ATI limitation. No formal statement was required to make the election. The taxpayer could then later revoke that election by filing an amended return or form using the 30 percent limit. Similarly, to use 2019 ATI for 2020, the taxpayer filed using 2019 ATI (and could then later revoke that election by filing a timely amended return or form). Partnerships could elect out of the 50 percent EBIE rule by not applying the CARES Act rule on their return, and could later revoke that election on an amended return or form.<a href="#_ftn9" name="_ftnref9">9</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 163(j)(10)(A)(i). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 163(j)(10)(B). <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 163(j). <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 163(j)(1). <a href="#_ftnref5" name="_ftn5">5</a>. IRC §§ 163(j)(2), 448(c), Rev. Proc. 2023-34. <a href="#_ftnref6" name="_ftn6">6</a>. IRC § 163(j)(8). <a href="#_ftnref7" name="_ftn7">7</a>. IRC § 163(j)(9). <a href="#_ftnref8" name="_ftn8">8</a>. IRC § 163(j)(2). <a href="#_ftnref9" name="_ftn9">9</a>. Rev. Proc. 2020-22. </div>

March 13, 2024

8050 / Are expenses paid for the production of tax-exempt income deductible?

<div class="Section1">Any expense that would otherwise be deductible under any Internal Revenue Code section is not deductible if it is allocable to tax-exempt income other than tax-exempt interest.<a href="#_ftn1" name="_ftnref1">1</a> Expenses allocable to tax-exempt interest may be deductible if they are trade or business expenses, taxes, or depreciation, but the same expenses allocable to tax-exempt income other than interest are not deductible.</div> <div class="Section1"> If an expense is allocable to both nonexempt income and exempt income, a reasonable proportion, determined in the light of all the facts and circumstances, is allocated to each.<a href="#_ftn2" name="_ftnref2">2</a> Legal fees incurred to collect Social Security benefits have been held deductible only to the extent that they were allocable to the portion of benefits that were includable in the taxpayer’s gross income.<a href="#_ftn3" name="_ftnref3">3</a> In the absence of evidence showing a more reasonable basis for allocation, the expense has been allocated between taxable and tax-exempt income in the proportion that each bears to the total taxable and nontaxable income in the year.<a href="#_ftn4" name="_ftnref4">4</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 265(a)(1). <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.265-1(c). <a href="#_ftnref3" name="_ftn3">3</a>. Rev. Rul. 87-102, 1987-2 CB 78. <a href="#_ftnref4" name="_ftn4">4</a>. Jamison v. Comm., 8 TC 173 (1947); Ellis v. Comm., 6 TCM 662 (1947); Mallinckrodt v. Comm., 2 TC 1128 (1943), acq., Rev. Rul. 59-32, 1959-1 CB 245, as clarified by Rev. Rul. 63-27, 1963-1 CB 57. </div>

March 13, 2024

8037 / Can a taxpayer deduct mortgage interest overcharges that are later reimbursed?

<div class="Section1">Editor’s Note: The 2017 tax reform legislation changed the rules governing the treatment of mortgage interest, home equity indebtedness interest and interest on debts to secure refinancing. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8034">8034</a> for details.<div class="Section1"> Taxpayers generally are not permitted a deduction for an interest payment made on a debt for which no liability exists or reasonably appears to exist. However, if a taxpayer in good faith makes an interest payment on an adjustable rate mortgage (ARM), and a portion of the interest is later determined to have been erroneously charged, the taxpayer is permitted under IRC Section 163(a) to deduct the interest overcharge in the year paid. The taxpayer’s recovery of the overcharge is includable in the taxpayer’s gross income in the year of recovery, but only to the extent that the prior deduction of the overcharge reduced the taxpayer’s income tax in a prior tax year. This result is the same whether the lender refunds the overcharge or reduces the outstanding principal on the taxpayer’s mortgage by the amount of the overcharge.<a href="#_ftn1" name="_ftnref1">1</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  Rev. Rul. 92-91, 1992-2 CB 49. </div></div>

March 13, 2024

8047 / Is interest paid on amounts borrowed to purchase or carry market discount bonds deductible for bonds issued before July 19, 1984 and acquired before May 1, 1993?

<div class="Section1">If a market discount bond was issued before July 19, 1984 and acquired on the market after that date but before May 1, 1993, the taxpayer generally will not be required to treat any part of the gain on disposition that is attributable to market discount as interest income (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7645">7645</a>). However, if deferred interest expense on such a bond is deducted on disposition, an equal amount of any gain on the disposition must be treated as interest income.<a href="#_ftn1" name="_ftnref1">1</a> Similarly, if the bond is disposed of in a nonrecognition transaction, an interest characterization rule will apply at the time gain is recognized and the deferred interest expense is deducted by the transferee.<a href="#_ftn2" name="_ftnref2">2</a><div class="Section1"> If amounts are borrowed or indebtedness is continued to purchase or carry bonds that were issued and acquired on or before July 18, 1984 at a market discount, the interest expense paid in the year is not disallowed simply because market discount is not recognized until disposition of the bond. Furthermore, when gain attributable to the market discount is recognized it is treated as capital gain (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> for the treatment of capital gain). </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 1277(d), prior to repeal by OBRA ’93. <a href="#_ftnref2" name="_ftn2">2</a>.  See General Explanation–TRA ’84, p. 98. </div></div>

March 13, 2024

8036 / How does refinancing of a taxpayer’s mortgage debt impact the taxpayer’s mortgage interest deduction?

<div class="Section1">Editor’s Note: The 2017 tax reform legislation changed the rules governing the treatment of mortgage interest, home equity indebtedness interest and interest on debts to secure refinancing. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8034">8034</a> for details.<div class="Section1"> Refinancing of a debt that was incurred to acquire, construct, or substantially improve a residence will be treated in the same manner as the first debt, to the extent that the proceeds are used to refinance the first debt. (The tracing rules found in Temporary Treasury Regulation Section 1.163-8T are used to determine how the proceeds are used. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8043">8043</a>.) If a taxpayer uses part of the loan proceeds to refinance an existing debt and the remaining proceeds for other purposes, the debt may qualify as acquisition indebtedness to the extent of the refinancing. The remaining debt may qualify as home equity indebtedness, up to the applicable limits. Under the 2017 tax reform legislation, debt amounts that are related to a refinancing will be treated as though incurred on the date that the original debt was incurred, provided that any additional amounts of debt incurred as a result of the refinancing do not exceed the amount of the refinanced debt. However, this exception does not apply if the refinancing occurs after the expiration of the term of the original debt. Further, it does not apply if the original debt was not amortized over its term, the expiration of the term of the first refinancing of the debt or, if earlier, the date which is 30 years after the date of the first refinancing.<a href="#_ftn1" name="_ftnref1">1</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 163(h)(3)(F)(iii). </div></div>

March 13, 2024

8038 / How is mortgage interest debt that is incurred to acquire the interest of a taxpayer’s spouse or former spouse pursuant to a divorce treated?

<div class="Section1">Editor’s Note: The 2017 Tax Act changed the rules governing the treatment of mortgage interest, home equity indebtedness interest and interest on debts to secure refinancing. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8034">8034</a> for details.<div class="Section1"> Regulations will provide that a debt incurred to acquire the interest of a spouse or former spouse pursuant to a divorce or legal separation will be treated as debt incurred to acquire a residence (for purposes of the definition of acquisition indebtedness in IRC Section 163) without regard to the treatment the transaction would otherwise receive under IRC Section 1041 (regarding transfers incident to divorce).<a href="#_ftn1" name="_ftnref1">1</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  Notice 88-74, 1988-2 CB 385. See also Let. Rul. 8928010. </div></div>

March 13, 2024

8042 / How is the investment interest deduction coordinated with the passive loss rules?

<div class="Section1">The investment interest limitation is coordinated with the passive loss rules (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8010">8010</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8021">8021</a>), so that interest and income subject to the passive loss rules are not taken into consideration under the investment interest limitation.<a href="#_ftn1" name="_ftnref1">1</a> Interest expense incurred to purchase an interest in a passive activity is allocated to that passive activity and is not investment interest.<a href="#_ftn2" name="_ftnref2">2</a> (Very generally, a passive activity is any activity that involves the conduct of a trade or business in which the taxpayer does not materially participate and any rental activity.)<a href="#_ftn3" name="_ftnref3">3</a> However, portfolio income of a passive activity and expense (including interest expense) allocable to it is considered investment income and expense, not passive income and expense.<a href="#_ftn4" name="_ftnref4">4</a><div class="Section1"> Temporary regulations provide that, for purposes of the investment interest and passive loss rules, interest expense is generally allocated on the basis of the use of the proceeds of the underlying debt (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8043">8043</a>). </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC §§ 163(d), 469. <a href="#_ftnref2" name="_ftn2">2</a>.  Temp. Treas. Reg. § 1.163-8T(a)(4)(B). <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 469. <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 469(e)(1). </div></div>

March 13, 2024

8046 / Is interest paid on amounts borrowed to purchase or carry market discount bonds deductible for bonds issued after July 18, 1984, and bonds issued before July 19, 1984 and acquired after April 30, 1993?

<div class="Section1">If amounts are borrowed or indebtedness is continued in order to purchase or carry a bond issued after July 18, 1984 at a market discount, or a bond issued before July 19, 1984 and purchased on the market at a discount after April 30, 1993, the interest expense is deductible to the extent that stated interest (or original issue discount) paid or accrued on it is includable in income for the year. (For the income tax treatment of market discount upon disposition of such bonds, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7645">7645</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7648">7648</a>.) If interest expense exceeds that amount, it will be deductible to the extent that it exceeds the market discount allocable to the days on which the bond was held during the tax year. Interest expense that is allocable to the market discount accruing in the year is not currently deductible; the deduction is deferred.<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> Amounts so disallowed in one year may be deductible in a later year in which includable interest on the obligation is greater than the interest expense for that year. Generally, the taxpayer may elect, on a bond by bond basis, to deduct an amount of previously disallowed interest expense up to the difference.<a href="#_ftn2" name="_ftnref2">2</a> Any deferred interest expense not previously deducted under that election becomes deductible in the year in which the bond is sold or redeemed. If the bond is disposed of in a transaction in which part or all of the gain is not recognized (e.g., a gift), the deferred interest is allowed as a deduction at that time only to the extent that gain is recognized. (See, e.g., Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7646">7646</a> with respect to gain that is recognized on a gift.) To the extent deferred interest expense is not allowed as a deduction upon the disposition of the bond in such a nonrecognition transaction, the disallowed interest expense will be treated as disallowed interest expense of the transferee of transferred basis property, or the transferor who receives exchanged basis property in the transaction.<a href="#_ftn3" name="_ftnref3">3</a> (Transferred basis property is property having a basis determined in whole or in part by the basis of the transferor.<a href="#_ftn4" name="_ftnref4">4</a> Exchanged basis property is property having a basis determined in whole or in part by other property held at any time by the person for whom the basis is being determined.)<a href="#_ftn5" name="_ftnref5">5</a> Thus, in the case of a market discount bond that is transferred basis property (a gift, for example), the transferee will be entitled to deduct the previously disallowed interest expense as if it were his own. On the other hand, interest expense allocable to market discount is currently deductible, not deferred, if the taxpayer has elected to treat the market discount as current income as it accrues under either the straight line or constant interest rate method.<a href="#_ftn6" name="_ftnref6">6</a> This election is discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7644">7644</a>.Unless the interest expense on borrowing is greater than the sum of (1) interest income on the bond that would be includable in gross income in the absence of the election plus (2) the amount of market discount accruing over the days the bond was held in the year, the election will merely result in a wash; in other words, the deduction and the included interest will offset each other. Whether amounts are borrowed or loans continued in order to purchase or carry market discount bonds depends on the taxpayer’s purpose for borrowing. In determining the individual’s purpose, the IRS will, presumably, apply the same principles applied in determining if indebtedness is incurred or continued to purchase or carry tax-exempt bonds (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8044">8044</a>). Noncapitalized expenses incurred in short sales of securities are treated as interest expenses subject to the deferred deduction rules if the proceeds of the short sales are used to purchase or carry a market discount bond.<a href="#_ftn7" name="_ftnref7">7</a> During the time the deduction of interest is deferred because it is on indebtedness incurred or continued to purchase or carry market discount bonds (or is an expense of a short sale the proceeds of which are used to purchase or carry market discount bonds), the interest (or short sale) expense is not counted as interest expense for other purposes (for example, in disallowing interest on amounts borrowed to buy tax-exempt bonds). </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 1277. <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 1277(b)(1)(A). <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 1277(b)(2). <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 7701(a)(43). <a href="#_ftnref5" name="_ftn5">5</a>.  IRC § 7701(a)(44). <a href="#_ftnref6" name="_ftn6">6</a>.  IRC § 1278(b). <a href="#_ftnref7" name="_ftn7">7</a>.  IRC § 1277(c). See General Explanation–TRA ’84, p. 98. </div></div>