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Understanding Investment Interest Expense on Form 1065

For partnerships, including Limited Liability Companies (LLCs) taxed as partnerships, understanding how to handle investment interest expense is crucial for accurate tax reporting. This expense arises when a partnership borrows money to purchase or carry investments. Form 1065, *U.S. Return of Partnership Income*, is used to report this information to the IRS. Unlike personal tax returns where investment interest expense is often deductible, the deduction at the partnership level has specific rules and limitations that need careful attention. The primary goal is to determine the amount of investment interest expense deductible by the partners. This is **not** deducted at the partnership level to calculate partnership income or loss. Instead, the deductible amount is calculated and then allocated to each partner according to their distributive share, as outlined in the partnership agreement. Each partner then reports their share of the investment interest expense on their individual tax return (usually Schedule A, subject to individual limitations). Investment interest expense is defined as interest paid or accrued on debt properly allocable to property held for investment. This includes interest paid on margin accounts, loans used to purchase stocks, bonds, or other investment property. However, it **does not** include interest expense that is properly allocable to a trade or business activity, even if the business activity involves investing. For example, interest paid on a loan used to acquire a rental property would not be considered investment interest expense, but rather a deduction related to rental real estate. The deduction for investment interest expense is limited to the partnership’s net investment income. Net investment income is the excess of investment income over investment expenses. * **Investment Income** includes items like interest, dividends, royalties, and net short-term capital gains attributable to the disposition of property held for investment. It also includes income from activities involving a trade or business if the property producing the income is property held for investment. * **Investment Expenses** are those expenses (other than interest) directly connected with the production of investment income. These are only deductible if they are *ordinary and necessary*. Examples include safe deposit box rentals (if used to store investment-related documents or valuables) and investment advisory fees. Critically, these expenses are subject to the 2% adjusted gross income (AGI) limitation at the partner level on their individual returns. The partnership itself does not deduct these expenses directly. Form 1065 instructions provide guidance on how to calculate the deductible investment interest expense. Typically, a worksheet (or similar calculation) is used to determine the limitation and the deductible amount. This worksheet aggregates investment income and investment expenses to arrive at net investment income. The deductible investment interest expense cannot exceed this amount. Any disallowed investment interest expense is carried forward indefinitely and can be deducted in future years, subject to the net investment income limitation in those years. This carryforward amount is allocated to each partner as well. On Schedule K-1 (Form 1065), each partner receives their allocated share of the investment interest expense, investment income (if applicable), and investment expenses. The K-1 instructions will provide specific guidance on how each partner should report these amounts on their individual tax returns. Careful record-keeping is essential for accurately calculating and reporting investment interest expense. Documentation should be maintained to support the allocation of debt proceeds to investment property, the payment of interest, and the calculation of investment income and expenses. Partners must then correctly report the information provided on Schedule K-1 on their individual tax returns, considering their own individual circumstances and limitations. Consulting with a qualified tax professional is always advisable to ensure compliance and optimize tax benefits.

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