Interest Expense Allocation

Taxable Income: Gross Income Minus Deductions

In the U.S., income tax applies to taxable income, which is calculated as gross income minus eligible deductions.

Exempt or Excluded Income and Related Expenses

Certain types of income, such as Puerto Rican-source income earned by bona fide residents of Puerto Rico, can be excluded from U.S. taxable income. However, U.S. tax law prohibits deductions for expenses related to excluded income.

For example:

• Section 265(a) disallows deductions for expenses tied to tax-exempt income.
• Section 911(d)(6) and Section 933(1) prevent claiming deductions for expenses associated with excluded income under Sections 911(a) and 933, respectively.

Expense Allocation Rules

When a taxpayer has both excluded and taxable income, they must allocate expenses between these categories. Deductions are only disallowed for expenses directly connected to excluded income.

Regulations under Section 861 provide detailed guidelines for allocating expenses between U.S.-source and foreign-source income. Bona fide Puerto Rican residents must carefully apply these rules to allocate expenses between taxable and excluded income.

Interest Expense Allocation Principles

Interest expenses are treated as related to all income-generating activities and assets, as money is considered fungible. This means that interest costs are allocated across all activities and properties that produce income.

Interest Expense Allocation for Individuals

Interest expenses are categorized and allocated based on the type of income or assets involved:

1. Trade or business interest: Allocated using an asset-based approach linked to business assets.
2. Investment interest: Allocated based on investment assets.
3. Passive activity interest: Tied to passive activity assets.
4. Qualified residence interest: Allocated according to gross income.

The Asset Method & Asset Classification

The asset method is used to allocate business, investment, and passive activity interest expenses. It involves determining the average tax basis of assets in three categories:

1. Business assets (worldwide)
2. Investment assets (worldwide)
3. Passive activity assets (worldwide)

The average tax basis is calculated using asset values at the start and end of the tax year. Assets are further classified based on the type of income they generate or are expected to generate.

Sub-Classifying Assets by Source

Under Section 861, assets must also be classified based on the source of the income they produce:

• Puerto Rican-source income (statutory grouping)
• Non-Puerto Rican-source income (residual grouping)

Interest expenses are then allocated to these categories. For bona fide Puerto Rican residents, the portion of interest expense allocated to Puerto Rican-source income excluded under Section 933 is not deductible.

Partnership Interest Allocation

1. General Partners and 10%+ Limited Partners
   These individuals must follow the aggregate rule, which includes their proportional share of the partnership’s interest expense and assets in the allocation process.

2. Limited Partners with Less Than 10% Ownership
   The entity rule applies. Interest expense is allocated based on the partner’s share of the partnership’s gross income rather than assets.

S Corporations

While S corporations share some similarities with partnerships, they are not treated as partnerships under Section 933. For S corporations:

1. Determine the individual’s average tax basis in S corporation shares.
2. Identify the type of income generated (business, investment, or passive).
3. Allocate interest expenses using the asset method based on the income source.

By applying these principles and allocation rules, taxpayers can ensure compliance with U.S. and Puerto Rican tax laws while properly handling deductions tied to taxable and excluded income.