The Prepaid Interest Deduction Viewed from the Perspective of Real Estate Transactions

SMU Law Review Volume 29 Issue 1 Annual Survey of Texas Law Article 18 1975 The Prepaid Interest Deduction Viewed from the Perspective of Real Estate Transactions David J. Graham Follow this and additional works at: https://scholar.smu.edu/smulr Recommended Citation David J. Graham, The Prepaid Interest Deduction Viewed from the Perspective of Real Estate Transactions, 29 Sw L.J. 412 (1975) https://scholar.smu.edu/smulr/vol29/iss1/18 This Comment is brought to you for free and open access by the Law Journals at SMU Scholar. It has been accepted for inclusion in SMU Law Review by an authorized administrator of SMU Scholar. For more information, please visit http://digitalrepository.smu.edu. COMMENTS THE PREPAID INTEREST DEDUCTION VIEWED FROM THE PERSPECTIVE OF REAL ESTATE TRANSACTIONS by David 1. Graham Real estate transactions have played a significant role in shaping the existing law regarding the deductibility of prepaid interest. The flourishing real estate market of the middle to late sixties was enhanced by the tax benefi-ts of prepaid interest,' and the tax avoidance use of the prepaid interest deduction became notorious through its connection with real estate tax shelters. 2 In 1968 the Internal Revenue Service responded to this form of tax avoidance by issuing Revenue Ruling 68-6433 which reversed its longstanding position that prepaid interest is deductible by a cash basis taxpayer in the year of payment. The ruling provides that a deduction will not be allowed for interest prepaid for more than twelve months beyond the taxable year in question as it constitutes a material distortion of income. While the abuses which existed prior to the issuance of the ruling mandated some change in the law, serious questions have arisen as to the validity of the Service's automatic disallowance approach. The purpose of this Comment is to analyze the trends of the law of prepaid interest from the perspective of the real estate tax shelter and to suggest the direction in which the law should develop in this area. Part I illustrates the use and advantages of prepaid interest in real estate transactions. A presentation of the general development of the law of prepaid interest is provided in part 11, including an indication of the abuses which led to the issuance of Revenue Ruling 68-643 and a discussion of the specific provisions of that ruling. Part III deals with the law affecting prepaid interest subsequent to 1968 and particularly with the judicial cognizance of the 1968 revenue ruling. An analysis of the various theories on which a prepaid 1. Prepaid interest refers to the payment of interest on an indebtedness before that interest accrues. The tax advantage of such a technique depends upon the ability of the taxpayer to take a deduction for the amount paid. A prepaid interest acquisition has been defined as one involving (1) an acquisition in which the buyer's promissory note represents most of the purchase price and (2) the buyer's prepayment of several years' interest on the purchase money note. See Kaster, Prepaid Interest Purchase Method Still Useful Despite IRS Attack, 30 J. TAx. 16 (1969). 2. A tax shelter transaction is one -designed to reduce tax liability by generating deductions in excess of income, thereby "sheltering" high bracket income which has accrued from other sources. Real estate investments have traditionally been regarded as attractive tax shelters because of the potential deductions such as accelerated depreciation and prepaid interest. For a discussion of several limitations on the use of tax shelters enacted in the Tax Reform Act of 1969, 83 Stat. 487, see Cunnane, Tax Shelter Investments After the 1969 Tax Reform Act, 49 TAXES 450 (1971). The proposed Tax Equity Act of 1975 limits tax shelter aspects of rental property by requiring the capitalization of interest and taxes incurred during periods of construction of rental property rather than allowing the current deduction of such expenses. See H.R. 1040, 94th Cong., 1st Sess. (1975). 3. 1968-2 CuM. BULL. 76. 19751 COMMENTS interest deduction may be disallowed in the context of real estate transactions is included in part IV. In part V some conclusions are drawn regarding the validity of the 'Internal Revenue Service's approach to the ruling in light of the abuses which precipitated its issuance and the disparate approaches of the courts and the Service in applying the material distortion of income theory. Finally, the trends and impact of future decisions on the prepaid interest deduction are considered. I. THE PREPAID INTEREST DEDUCTION The statutory foundation for the interest deduction consists of a clear and simple statement in section 163 of the Internal Revenue Code: "There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness." ' 4 The Code does not provide a definition of the word "interest" but the term is regarded by the courts and by the Internal Revenue Service as meaning "the amount which one has contracted to pay for the use, forbearance, or detention of money." 5 The basic statutory provision is broad,6 allowing a deduction for interest in the year paid or accrued, provided that the interest arises from a genuine indebtedness 7 and that the payment is actually interest rather than a disguised payment of principal. 8 Assuming that these fundamental requirements are met, the cash basis taxpayer may have a useful tax-planning device through his control over 'the timing of an interest deduction.) The timing decision essentially involves choosing the tax year in which the interest payment is to be made. For example, a taxpayer expecting to have a greater need for a deduction in the 4. INT. REV. CODE OF 1954, § 163(a). 5. Old Colony R.R. v. Commissioner, 284 U.S. 552 (1932); cf. Deputy v. DuPont, 308 U.S. 488 (1940); Rev. Rul. 72-315, 1972-1 CuM. BULL. 49; Rev. Rul. 71-98, 1971- 1 CuM. BULL. 57; Rev. Rul. 69-290, 1969-1 CuM. BULL. 55; Rev. Rul. 69-189, 19691 CUM. BULL. 55; Rev. Rul. 69-188, 1969-1 CUM. BULL. 54. The Internal Revenue Code provides several specific limitations on the interest deduction. See, e.g., INT. REV. CODE OF 1954, § 264 (limitation of interest deduction for interest incurred in connection with life insurance contracts); id. § 265 (limitation on interest deduction arising in connection with tax exempt interest income); id. § 269 (limitation on interest deduction arising in connection with corporate acquisitions). 6. There is no statutory requirement that the interest deduction be reasonable in amount. See, e.g., Dorzback v. Collison, 195 F.2d 69 (3d Cir. 1952) (payment of 25% of profits as interest held to be deductible under § 163). Furthermore, the deduction may be taken regardless of whether the indebtedness is incurred 'for a business purpose. INT. REV. CODE OF 1954, § 163(a). But see notes 55-58 infra and accompanying text for a discussion of the purposive activity doctrine. 7. See notes 47-50 infr (...truncated)