Interest Expense Allocation

Taxable Income – Gross Income Minus Deductions

In the U.S., income tax is typically applied to taxable income, which is defined as gross income minus allowable deductions.

Exempt or Excluded Income and Associated Expenses

Certain types of income can be excluded from taxable income under U.S. tax law. Specifically, bona fide residents of Puerto Rico can exclude income earned from Puerto Rican sources from their taxable income.

However, when income is excluded, U.S. tax law prohibits claiming deductions for expenses tied to that income. For instance, Section 265(a) of the Internal Revenue Code states that no deduction can be claimed for expenses connected to income that is exempt from taxation. Additionally, Section 911(d)(6) prevents deductions related to income excluded under Section 911(a), while Section 933(1) similarly disallows deductions for income excluded under Section 933 for Puerto Rican residents.

Allocating Expenses

Deductions can only be disallowed for expenses directly related to excluded income. Therefore, when a taxpayer has both exempt and taxable income, they must allocate their expenses between the two types of income.

Regulations under Section 861 provide detailed guidance on how to allocate expenses between U.S.-source and foreign-source income. These rules are applied in various contexts, including for determining exclusions under Section 933.

Thus, bona fide Puerto Rican residents who earn both taxable and excluded income need to carefully allocate their expenses between these categories.

Interest Expense Allocation Overview

Interest expense allocation follows the principle that money is interchangeable, meaning interest costs are connected to all income-generating activities and properties, regardless of the specific purpose for incurring the debt. This concept of fungibility is reflected in the regulations, which treat interest expense as being applicable to all activities and assets that produce income for the taxpayer.

Interest Expense Allocation for Individuals

For individuals, the allocation of interest expense is typically based on the type of interest incurred. Interest expenses must be classified into the following categories:

1. Trade or business interest is allocated by linking it to the individual’s business assets using an asset-based approach.

2. Investment interest is allocated based on the individual’s investment assets.
3. Passive activity interest is assigned according to the individual’s passive activity assets.
4. Qualified residence interest is allocated using a method tied to the individual’s gross income.

Asset Method & Classification of Assets

The asset method is used to allocate interest expenses for business, investment, and passive activity interests. To calculate the necessary allocation, the individual must determine the average tax basis of their assets in three categories: (i) worldwide business assets, (ii) worldwide investment assets, and (iii) worldwide passive activity assets. The average is calculated using the asset values at both the beginning and the end of the year.

Assets are categorized based on the type of income they generate, have generated, or are expected to generate.

Sub-Classification of Assets (By Source)

As previously noted, the Code §861 rules for expense allocation are applied for various purposes. In this case, the focus is on bona fide residents of Puerto Rico. The goal is to determine the portion of otherwise deductible interest expense that should be allocated to income excluded under Code §933. Any interest expense allocated to excluded income will not be deductible.

After determining the average tax basis of the assets in the three categories (business, investment, and passive activity), these assets must be further divided by the source of the income they produce:

• Puerto Rican-source income
• Non-Puerto Rican-source income

In the regulations, Puerto Rican-source income is referred to as the “statutory grouping” of gross income, while non-Puerto Rican-source income is referred to as the “residual grouping” of gross income.

Once the assets generating Puerto Rican-source and non-Puerto Rican-source income have been identified for each category, the interest expense allocation can be completed.

Partnerships – General Partners & Limited Partners Owning 10% or More (Aggregate Rule)

Individuals who are general partners, as well as those limited partners owning 10% or more of the partnership, must follow the “aggregate rule.” Under this rule, these individuals include their proportional share of the partnership’s interest expense and assets when applying the interest expense allocation rules. This means that their individual interest expense allocations take into account not only their direct expenses but also the partnership’s interest expense and assets according to their ownership share.

Partnerships – Limited Partners Owning Less Than 10% (Entity Rule & Income Method)

An individual who is a limited partner with less than 10% ownership in the partnership must apply the “entity rule.” Under this rule, the individual allocates their share of the partnership’s interest expense based on their share of the partnership’s gross income, rather than using the asset method. This means that instead of considering the partnership’s assets, the interest expense is allocated according to the income generated by the partnership in which the individual has an interest.

S Corporations

While an S corporation is generally treated as a partnership for some purposes, it is not considered a partnership for the purposes of Code §933. Therefore, a bona fide resident of Puerto Rico would not apply the partnership aggregate rule to an S corporation. Instead, the individual must follow these steps: (1) determine their average tax basis in the shares of the S corporation, (2) identify the type of income the S corporation generates (business, investment, or passive activity), and (3) determine the source of that income. These factors are then used to allocate interest expenses according to the asset method.