Interest tracing rules in real estate partnerships: debt-financed distributions, refinances, and 1031 exchanges impact interest deductibility.
In the real estate industry, debt-financed distributions are a common way to return capital to partners. But the tax treatment of the related interest expense is governed by the interest tracing rules under Treasury Regulation Section 1.163-8T.
These rules require careful attention, not just at the time of borrowing, but also when refinancing or engaging in transactions such as Section 1031 exchanges.
Understanding debt-financed distributions
A debt-financed distribution occurs when a partnership borrows funds and distributes the proceeds to partners.
The deductibility of the interest depends on how each partner uses the funds, not how the partnership uses the loan or what secures it. If a partner invests the funds, the interest may be deductible as investment interest. If the funds are used personally, the interest is generally non-deductible.
Refinancing and the continuity of interest tracing
When a loan is refinanced, the IRS permits the new loan to inherit the traced use of the original loan, provided it replaces the same principal amount. In other words, the new loan “steps into the shoes” of the original, and the interest expense retains its original character.
A partnership borrows $10 million in 2020 for a distribution. In 2025, it refinances with a $12.5 million loan. The $10 million refinanced portion keeps its original interest treatment. The additional $2.5 million, used for capital improvements, has its own tracing and may be deductible as business or investment interest.
Loan timing matters
If there is a gap between paying off the original loan and securing the new one, the tracing rules may not automatically apply. The IRS will evaluate the facts to determine whether the new loan continues the original purpose.
Section 1031 exchanges do not reset tracing
A common misconception is that a Section 1031 exchange eliminates the tax consequences of a prior debt-financed distribution.
The interest tracing rules remain in effect as the focus should be on the use of proceeds, not the collateral. Therefore, even after a successful Section 1031 exchange, the interest on the original debt must still be traced to the partner’s use of the distributed funds.
If the distribution and Section 1031 exchange are closely linked, the IRS may treat them as a step transaction, potentially triggering gain recognition under Internal Revenue Code Section 731 or 707.
How CLA can help
CLA’s real estate tax professionals can help you navigate the complexities of debt-financed distributions, mortgage refinances, and Section 1031 exchanges. If you are planning a distribution, restructuring debt, or executing a like-kind exchange, CLA is prepared to advise you.