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Friday, February 29, 2008

DEDUCTIBILITY FOR HEDGE FUND INTEREST IS LIMITED

The classification of an expense of a trade or business as a “passive loss” or “investment interest” is not usually desirable for individual taxpayers, since such losses can only be offset against certain specified types of income. If such classification is avoided, these limitations on use are likewise avoided.

For hedge funds and other partnerships involving active trading in securities, such partnership activities can be characterized as a trade or business. Nonetheless, and unlike most other trades or businesses, under IRS regulations losses from such activities cannot be characterized as “passive losses.” Treas.Regs. §1.469-1T(e)(6)(i).

Often such partnership borrow funds to use in their business. At first it may appear that interest payments on such borrowings, when passed through to individual limited partners, should be fully deducted as trade or business expenses of the partners since under the above regulation they have dodged characterization as “passive losses.” However, in a recent Revenue Ruling, the IRS has indicated that in their analysis, such interest expense will be characterized as “investment interest.” As such, it is deductible by individual partners that do not materially participate in the partnership business under Code Section 163(d)(1) only to the extent they have “net investment income.” Thus, while the passive loss limitations are avoidable, for this type of expense the investment interest limits will apply.

Such interest expense will need to be separately stated on the partnership’s K-1 schedule to partners, so that the partners can properly account for it on their own tax returns based on their individual circumstances.

Revenue Ruling 2008-12, IRB 2008-10
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