26 CFR §1.469-7 — -7 Treatment of self-charged items of interest income and deduction.

1. (a)In general
   1. (1)Applicability and effect of rules. This section sets forth rules that apply, for purposes of section 469 and the regulations thereunder, in the case of a lending transaction (including guaranteed payments for the use of capital under section 707(c)) between a taxpayer and a passthrough entity in which the taxpayer owns a direct or indirect interest, or between certain passthrough entities. The rules apply only to items of interest income and interest expense that are recognized in the same taxable year. The rules—
      1. (i)Treat certain interest income resulting from these lending transactions as passive activity gross income;
      2. (ii)Treat certain deductions for interest expense that is properly allocable to the interest income as passive activity deductions; and
      3. (iii)Allocate the passive activity gross income and passive activity deductions resulting from this treatment among the taxpayer's activities.
   2. (2)Priority of rules in this section. The character of amounts treated under the rules of this section as passive activity gross income and passive activity deductions and the activities to which these amounts are allocated are determined under the rules of this section and not under the rules of §§ 1.163-8T, 1.469-2(c) and (d), and 1.469-2T(c) and (d).
2. (b)Definitions. The following definitions set forth the meaning of certain terms for purposes of this section:
   1. (1)Passthrough entity. The term passthrough entity means a partnership or an S corporation.
   2. (2)Taxpayer's share. A taxpayer's share of an item of income or deduction of a passthrough entity is the amount treated as an item of income or deduction of the taxpayer for the taxable year under section 702 (relating to the treatment of distributive shares of partnership items as items of partners) or section 1366 (relating to the treatment of pro rata shares of S corporation items as items of shareholders).
   3. (3)Taxpayer's indirect interest. The taxpayer has an indirect interest in an entity if the interest is held through one or more passthrough entities.
   4. (4)Entity taxable year. In applying this section for a taxable year of a taxpayer, the term entity taxable year means the taxable year of the passthrough entity for which the entity reports items that are taken into account under section 702 or section 1366 for the taxpayer's taxable year.
   5. (5)Deductions for a taxable year. The term deductions for a taxable year means deductions that would be allowable for the taxable year if the taxpayer's taxable income for all taxable years were determined without regard to sections 163(d), 170(b), 469, 613A(d), and 1211.
3. (c)Taxpayer loans to passthrough entity
   1. (1)Applicability. Except as provided in paragraph (g) of this section, this paragraph (c) applies with respect to a taxpayer's interest in a passthrough entity (borrowing entity) for a taxable year if—
      1. (i)The borrowing entity has deductions for the entity taxable year for interest charged to the borrowing entity by persons that own direct or indirect interests in the borrowing entity at any time during the entity taxable year (the borrowing entity's self-charged interest deductions);
      2. (ii)The taxpayer owns a direct or an indirect interest in the borrowing entity at any time during the entity taxable year and has gross income for the taxable year from interest charged to the borrowing entity by the taxpayer or a passthrough entity through which the taxpayer holds an interest in the borrowing entity (the taxpayer's income from interest charged to the borrowing entity); and
      3. (iii)The taxpayer's share of the borrowing entity's self-charged interest deductions includes passive activity deductions.
   2. (2)General rule. If any of the borrowing entity's self-charged interest deductions are allocable to an activity for a taxable year in which this paragraph (c) applies, the passive activity gross income and passive activity deductions from that activity are determined under the following rules—
      1. (i)The applicable percentage of each item of the taxpayer's income for the taxable year from interest charged to the borrowing entity is treated as passive activity gross income from the activity; and
      2. (ii)The applicable percentage of each deduction for the taxable year for interest expense that is properly allocable (within the meaning of paragraph (f) of this section) to the taxpayer's income from the interest charged to the borrowing entity is treated as a passive activity deduction from the activity.
   3. (3)Applicable percentage. In applying this paragraph (c) with respect to a taxpayer's interest in a borrowing entity, the applicable percentage is separately determined for each of the taxpayer's activities. The percentage applicable to an activity for a taxable year is obtained by dividing—
      1. (i)The taxpayer's share for the taxable year of the borrowing entity's self-charged interest deductions that are treated as passive activity deductions from the activity by
      2. (ii)The greater of—
         1. (A)The taxpayer's share for the taxable year of the borrowing entity's aggregate self-charged interest deductions for all activities (regardless of whether these deductions are treated as passive activity deductions); or
         2. (B)The taxpayer's aggregate income for the taxable year from interest charged to the borrowing entity for all activities of the borrowing entity.
4. (d)Passthrough entity loans to taxpayer
   1. (1)Applicability. Except as provided in paragraph (g) of this section, this paragraph (d) applies with respect to a taxpayer's interest in a passthrough entity (lending entity) for a taxable year if—
      1. (i)The lending entity has gross income for the entity taxable year from interest charged by the lending entity to persons that own direct or indirect interests in the lending entity at any time during the entity taxable year (the lending entity's self-charged interest income);
      2. (ii)The taxpayer owns a direct or an indirect interest in the lending entity at any time during the entity taxable year and has deductions for the taxable year for interest charged by the lending entity to the taxpayer or a passthrough entity through which the taxpayer holds an interest in the lending entity (the taxpayer's deductions for interest charged by the lending entity); and
      3. (iii)The taxpayer's deductions for interest charged by the lending entity include passive activity deductions.
   2. (2)General rule. If any of the taxpayer's deductions for interest charged by the lending entity are allocable to an activity for a taxable year in which this paragraph (d) applies, the passive activity gross income and passive activity deductions from that activity are determined under the following rules—
      1. (i)The applicable percentage of the taxpayer's share for the taxable year of each item of the lending entity's self-charged interest income is treated as passive activity gross income from the activity.
      2. (ii)The applicable percentage of the taxpayer's share for the taxable year of each deduction for interest expense that is properly allocable (within the meaning of paragraph (f) of this section) to the lending entity's self-charged interest income is treated as a passive activity deduction from the activity.
   3. (3)Applicable percentage. In applying this paragraph (d) with respect to a taxpayer's interest in a lending entity, the applicable percentage is separately determined for each of the taxpayer's activities. The percentage applicable to an activity for a taxable year is obtained by dividing—
      1. (i)The taxpayer's deductions for the taxable year for interest charged by the lending entity, to the extent treated as passive activity deductions from the activity; by
      2. (ii)The greater of—
         1. (A)The taxpayer's aggregate deductions for all activities for the taxable year for interest charged by the lending entity (regardless of whether these deductions are treated as passive activity deductions); or
         2. (B)The taxpayer's aggregate share for the taxable year of the lending entity's self-charged interest income for all activities of the lending entity.
5. (e)Identically-owned passthrough entities
   1. (1)Applicability. Except as provided in paragraph (g) of this section, this paragraph (e) applies with respect to lending transactions between passthrough entities if each owner of the borrowing entity has the same proportionate ownership interest in the lending entity.
   2. (2)General rule. To the extent an owner shares in interest income from a loan between passthrough entities described in paragraph (e)(1) of this section, the owner is treated as having made the loan to the borrowing passthrough entity and paragraph (c) of this section applies to determine the applicable percentage of portfolio income of properly allocable interest expense that is recharacterized as passive.
   3. (3)Example. The following example illustrates the application of this paragraph (e):
6. (f)Identification of properly allocable deductions. For purposes of this section, interest expense is properly allocable to an item of interest income if the interest expense is allocated under § 1.163-8T to an expenditure that—
   1. (1)Is properly chargeable to capital account with respect to the investment producing the item of interest income; or
   2. (2)May reasonably be taken into account as a cost of producing the item of interest income.
7. (g)Election to avoid application of the rules of this section
   1. (1)In general. Paragraphs (c), (d) and (e) of this section shall not apply with respect to any taxpayer's interest in a passthrough entity for a taxable year if the passthrough entity has made, under this paragraph (g), an election that applies to the entity's taxable year.
   2. (2)Form of election. A passthrough entity makes an election under this paragraph (g) by attaching to its return (or amended return) a written statement that includes the name, address, and taxpayer identification number of the passthrough entity and a declaration that an election is being made under this paragraph (g).
   3. (3)Period for which election applies. An election under this paragraph (g) made with a return (or amended return) for a taxable year applies to that taxable year and all subsequent taxable years that end before the date on which the election is revoked.
   4. (4)Revocation. An election under this paragraph (g) may be revoked only with the consent of the Commissioner.
8. (h)Examples. The following examples illustrate the principles of this section. The examples assume for purposes of simplifying the presentation, that the lending transactions described do not result in foregone interest (within the meaning of section 7872(e)(2)), original issue discount (within the meaning of section 1273), or total unstated interest (within the meaning of section 483(b)).