                            153 T.C. No. 1



                  UNITED STATES TAX COURT



  WILLIAM C. LIPNICK AND DALE A. LIPNICK, Petitioners v.
   COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 1262-18.                          Filed August 28, 2019.



       P-H’s father owned interests in partnerships that made debt-
financed distributions to the partners. P-H’s father used the proceeds
of those distributions to purchase assets that he held for investment.
P-H’s father treated the interest paid by the partnerships on those
debts and passed through to him as “investment interest” subject to
the limitation on deductibility imposed by I.R.C. sec. 163(d).

       In 2011 and 2013 P-H’s father transferred interests in the part-
nerships to P-H by gift and bequest. The partnerships continued to
incur interest expense on the debts, which was passed through to P-H
as a new partner. P-H treated the debts as properly allocable to the
partnerships’ real estate assets and reported the interest expense on
his 2013 and 2014 Schedules E, Supplemental Income and Loss, as
offsetting the passed-through real estate income.

       For Ps’ taxable years 2013 and 2014, R characterized the inter-
est passed through to P-H as “investment interest.” Because Ps had
                                        -2-

      insufficient investment income for these years, R disallowed 100% of
      the deductions for interest expense under I.R.C. sec. 163(d).

             1.     Held: P-H, unlike his father, did not receive the pro-
      ceeds of any debt-financed distributions and did not use partnership
      distributions to acquire property held for investment. Rather, he is
      deemed to have made a debt-financed acquisition of the partnership
      interests he acquired by gift and bequest, and the associated interest
      expense is allocated among the assets of the partnerships.

            2.    Held, further, because the assets owned by the partner-
      ships were not property held for investment, none of the interest ex-
      pense passed through to P-H was “investment interest” subject to
      limited deductibility under I.R.C. sec. 163(d).

            3.     Held, further, the interest expense passed through to P-H
      cannot be characterized as “investment interest” on the theory that he
      stepped into his father’s shoes.



      Michael I. Sanders and Jill E. Misener, for petitioners.

      William J. Gregg, Bartholomew Cirenza, and Benjamin H. Weaver, for

respondent.



                                     OPINION


      LAUBER, Judge: With respect to petitioners’ Federal income tax for 2013

and 2014, the Internal Revenue Service (IRS or respondent) determined defi-

ciencies and accuracy-related penalties as follows:
                                         -3-

                          Year Deficiency Penalty

                          2013 $269,202        $53,840
                          2014 286,232          57,246

      During 2013 and 2014 petitioner husband (William or petitioner) partici-

pated in real estate partnerships that incurred interest expense. The real estate in-

come and associated expenses were passed through to him, and petitioners report-

ed those items on Schedules E, Supplemental Income and Loss. The question pre-

sented is whether petitioners properly offset the interest expense in full against the

real estate income on Schedules E, or whether (as respondent contends) they

should have reported the interest expense on Schedules A, Itemized Deductions,

subject to the limitation imposed by section 163(d) on “investment interest.”1 We

decide this question in petitioners’ favor, thus absolving them both of the defi-

ciencies and of the penalties.

                                    Background

      The parties submitted this case for decision without trial under Rule 122.

Relevant facts have been stipulated or are otherwise included in the record. See




      1
       All statutory references are to the Internal Revenue Code in effect for the
years at issue, and all Rule references are to the Tax Court Rules of Practice and
Procedure. We round all monetary amounts to the nearest dollar.
                                         -4-

Rule 122(a). Petitioners resided in Washington, D.C., when they filed their

petition.

A.    Lipnick/Cafritz Partnerships

      William is the son of Maurice Lipnick (Maurice), who died in October 2013

at age 95. For many years Maurice participated in partnerships with Calvin Caf-

ritz, a legendary real estate entrepreneur in the Washington, D.C., area. These

partnerships owned and operated rental real estate in the District and its suburbs.

As of 2009 Maurice’s investments2 included a 50% interest in Mar-Cal, LLC

(Mar-Cal), which owned apartment buildings in the District and suburban Mary-

land; a 50% interest in Mayfair House Apartments (Mayfair), which owned an

apartment building in Falls Church, Virginia; and a 25% interest in Brinkley Asso-

ciates, LLC (Brinkley), which owned rental real estate in Temple Hills, Maryland.

The remaining interest in each partnership was held by Mr. Cafritz.

      In June 2009 Mar-Cal, Mayfair, and Brinkley borrowed money from M&T

Realty Capital Corp. (M&T) and distributed the proceeds to Maurice and Mr.

Cafritz. Mar-Cal borrowed $22.7 million, Mayfair borrowed $15.25 million, and

Brinkley borrowed $41.5 million. The terms of the loans were substantially simi-


      2
      These interests were held by a grantor trust and were thus treated as being
owned by Maurice directly. See sec. 671.
                                         -5-

lar. Each loan had a 5.88% interest rate and a note secured by the partnership’s

assets, but neither Maurice nor Mr. Cafritz was personally liable on the notes.

      Out of these debt proceeds Mar-Cal, Mayfair, and Brinkley in June 2009

made debt-financed distributions to Maurice of $10,854,950, $4,790,857, and

$6,413,684, respectively. These funds were initially deposited in Maurice’s per-

sonal account at BB&T Bank. The cash was thereafter invested in money market

funds and other investment assets, and those assets were held in Maurice’s person-

al accounts until his death.

      During 2009-2011 Mar-Cal, Mayfair, and Brinkley incurred interest ex-

pense on the M&T loans. Each partnership issued to Maurice for each year a

Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., reporting his

distributive shares of its rental real estate income and interest expense. On his

Federal income tax return for each year, Maurice reported his distributive shares

of the interest expense on the M&T loans as “investment interest” on Schedule A.

      On July 31, 2011, Maurice transferred to William, by inter vivos gift, 50%

of his ownership interests in Mar-Cal, Mayfair, and Brinkley. William thereupon

agreed to be bound by each partnership’s operating agreement. But he did not be-

come personally liable on any of the M&T loans.
                                        -6-

      By gratuitously transferring to William his partnership interests in Mar-Cal,

Mayfair, and Brinkley, Maurice was relieved of his shares of the partnership liabil-

ities represented by the M&T loans. On his 2011 Federal income tax return, he

treated the nonrecourse partnership liabilities of which he was relieved as

“amounts realized” on the transfers. See secs. 1.752-1(h), 1.1001-2(a)(4)(v),

Income Tax Regs. He accordingly reported taxable capital gains of $10,026,045,

$6,492,303, and $8,667,786, respectively.

B.    Claridge Partnership

      Claridge House Alexandria Associates, L.P. (Claridge), a partnership for

Federal tax purposes, owned and operated rental real estate, including an apart-

ment complex in Alexandria, Virginia. Before his death Maurice held in Claridge

a 2.5% general partnership (GP) interest and a 10% limited partnership (LP) in-

terest. Maurice indirectly held an additional 5.498% LP interest in Claridge by

virtue of his 25% interest in the Lipnick Family Limited Partnership (Family LP).

      In February 2012 Claridge borrowed $20 million from Walker & Dunlop,

LLC (W&D) at an interest rate of 4.19% and distributed the proceeds to its part-

ners. The partnership’s note was secured by the partnership assets, but neither

Maurice nor any of the other partners was personally liable on the note. From

these debt proceeds Claridge distributed $1,683,864 directly to Maurice and
                                        -7-

$706,780 indirectly to Maurice through the Family LP. These funds were initially

deposited in Maurice’s personal bank account, and the cash was thereafter invest-

ed in money market funds and other investment assets that were held in Maurice’s

personal accounts until his death.

      Claridge during 2012 and 2013 incurred interest expense on the W&D loan.

Claridge issued to Maurice for each year Schedule K-1 reporting his distributive

shares of Claridge’s rental real estate income and interest expense. On his Federal

income tax return for each year, Maurice reported his distributive share of the

interest expense on the W&D loan as “investment interest” on Schedule A.

      Maurice died on October 15, 2013. His will bequeathed to William his

2.5% GP interest in Claridge, a 3.75% LP interest in Claridge, and half of his in-

terest in the Family LP. The latter gave William (indirectly) an additional 2.749%

LP interest in Claridge. After this bequest William did not become personally

liable on the W&D loan.

C.    Tax Reporting and IRS Examination

      The M&T and W&D loans remained outstanding during 2013 and 2014,

and the four partnerships paid interest on these loans. For 2013 Mar-Cal, Mayfair,

and Brinkley issued to William Schedules K-1 reporting that his distributive
                                         -8-

shares of the partnerships’ rental real estate income and interest expense attribut-

able to the M&T loans were:

                    Partnership     Income     Interest Expense

                     Mar-Cal       $515,018       $344,688
                     Mayfair        294,360        177,052
                     Brinkley       264,249        193,763

      For 2014 Mar-Cal, Mayfair, Brinkley, and Claridge issued Schedules K-1

reporting that William’s distributive shares of the partnerships’ rental real estate

income and interest expense attributable to the M&T and W&D loans were:3

                    Partnership    Income      Interest Expense

                     Mar-Cal      $511,433       $340,259
                     Mayfair       269,293        174,677
                     Brinkley      245,474        191,215
                     Claridge      208,750         25,751

      For 2013 and 2014 petitioners jointly filed Forms 1040, U.S. Individual In-

come Tax Return, attaching to each return a Schedule E. They took the position

that the interest paid by the partnerships on the M&T and W&D loans was not


      3
        The amounts shown for Claridge include amounts appearing on the Sched-
ule K-1 issued to William, plus William’s share of amounts shown on the Sched-
ule K-1 issued to the Family LP. The amounts passed through to William from the
Family LP included $7,866 of interest paid on the W&D loan (which is included
in the table) and $15,731 of miscellaneous investment interest (which petitioners
separately reported as investment interest on Schedule A of their 2014 return).
The latter amount is not at issue here.
                                         -9-

“investment interest,” as it had been in the hands of Maurice, because William had

not received any of the loan proceeds and had not used any partnership distribu-

tions to acquire investment assets. Rather, they treated the interest as having been

paid on indebtedness properly allocable to the partnerships’ real estate assets, and

hence treated William’s distributive shares of the interest expense as fully deduct-

ible against his distributive shares of the partnerships’ real estate income. Accord-

ingly, on each Schedule E they netted against the income for each partnership (as

shown in the tables above) the corresponding amount of interest expense (as

shown in the tables above). They reported the resulting net income on Forms

1040, line 17.

      On October 30, 2017, the IRS issued petitioners a timely notice of defi-

ciency for 2013 and 2014. It determined that William’s distributive shares of the

interest paid by the partnerships on the M&T and W&D loans should properly

have been reported on Schedules A as “investment interest.” Under section

163(d)(1), “investment interest” is deductible only to the extent of a taxpayer’s

“net investment income.” Because petitioners had insufficient investment income

for both years, the IRS disallowed deductions for all of the passed-through interest
                                         -10-

attributable to the M&T and W&D loans. It also determined accuracy-related

penalties under section 6662(a).4

      Petitioners timely petitioned this Court for redetermination of the deficien-

cies and the penalties. On December 20, 2018, the parties submitted the case for

decision without trial under Rule 122.

                                     Discussion

      The IRS’ determinations in a notice of deficiency are generally presumed

correct, and the taxpayer bears the burden of proving them erroneous. Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Petitioners do not contend

that the burden of proof should shift to respondent under section 7491(a). In any

event, because only legal issues remain, the burden of proof is irrelevant. See Nis

Family Tr. v. Commissioner, 115 T.C. 523, 538 (2000).

      4
        Neither party contends that any of the partnerships was subject to the audit
procedures of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA).
See secs. 6221-6234 (as in effect for years before 2018). Mar-Cal, Mayfair, and
Brinkley filed their 2013 and 2014 returns as small partnerships exempt from
TEFRA procedures. See sec. 6231(a)(1)(B). Each partnership checked a box indi-
cating that it was not electing to have TEFRA procedures apply. See sec.
6231(a)(1)(B)(ii). In any event, if the Commissioner “reasonably determines” on
the basis of a partnership’s return that TEFRA procedures do not apply for a par-
ticular year, “then the provisions of this subchapter shall not apply to such partner-
ship * * * for such taxable year or to partners of such partnership,” even if the
Commissioner’s determination is erroneous. Sec. 6231(g)(2). Claridge’s 2013
and 2014 partnership returns are not in the record, but neither party contends that
TEFRA procedures were applicable to it.
                                         -11-

A.    Governing Statutory and Regulatory Structure

      Section 163(a) generally provides that “[t]here shall be allowed as a deduc-

tion all interest paid or accrued within the taxable year on indebtedness.” For tax-

payers other than corporations, “personal interest” as defined in section 163(h) is

generally nondeductible. Nondeductible personal interest is defined to exclude

(among other things) “interest paid or incurred on indebtedness properly allocable

to a trade or business” and “any interest which is taken into account under section

469 in computing income or loss from a passive activity.” Sec. 163(h)(2)(A), (C).

Personal interest also excludes “any investment interest (within the meaning of

subsection (d)).” Sec. 163(h)(2)(B).

      Respondent contends that the interest paid by the partnerships on the M&T

and W&D loans and passed through to William constituted “investment interest.”

Section 163(d) allows a deduction for investment interest, but subject to a limita-

tion. Specifically, it provides that, “[i]n the case of a taxpayer other than a cor-

poration, the amount allowed as a deduction * * * for investment interest for any

taxable year shall not exceed the net investment income of the taxpayer for the

taxable year.” Sec. 163(d)(1).

      Petitioners had little net investment income for 2013 and 2014. They ac-

cordingly agree that, if the interest in question constituted “investment interest”
                                        -12-

under section 163(d), it would be nondeductible. And respondent agrees that, if

the interest was not “investment interest,” it was properly reportable and deduct-

ible on Schedule E.

      Investment interest is defined as interest that is “paid or accrued on indebt-

edness properly allocable to property held for investment.” Sec. 163(d)(3)(A).

The interest in question was incurred by Mar-Cal, Mayfair, Brinkley, and Cla-

ridge, which owned, operated, and actively managed apartment buildings and

other rental real estate. The loans on which the interest was paid were secured by

those real estate assets. Respondent does not contend that the operating assets

held by the partnerships constituted “property held for investment.”

      Temporary regulations, promulgated in 1987 but never finalized, provide a

tracing rule for determining when debt is “properly allocable to property held for

investment.” Sec. 163(d)(3)(A); see sec. 1.163-8T, Temporary Income Tax Regs.,

52 Fed. Reg. 24999 (July 2, 1987). Generally, “[d]ebt is allocated to expenditures

in accordance with the use of the debt proceeds and * * * interest expense accru-

ing on a debt * * * is allocated to expenditures in the same manner as the debt is

allocated.” Sec. 1.163-8T(c)(1), Temporary Income Tax Regs., 52 Fed. Reg.

25000 (July 2, 1987). “Debt is allocated,” in other words, “by tracing disburse-
                                         -13-

ments of the debt proceeds to specific expenditures.” Sec. 1.163-8T(a)(3),

Temporary Income Tax Regs., 52 Fed. Reg. 24999 (July 2, 1987).

      For example, if a taxpayer uses debt proceeds to make a personal expendi-

ture, such as taking a vacation, the interest is treated as nondeductible personal

interest. See sec. 163(h); sec. 1.163-8T(a)(4)(ii), Example (1), Temporary Income

Tax Regs., 52 Fed. Reg. 25000 (July 2, 1987). If a taxpayer uses debt proceeds in

connection with a passive activity, the interest is subject to the passive loss limita-

tions. See sec. 469; sec. 1.163-8T(a)(4)(ii), Example (1), Temporary Income Tax

Regs., supra. And if a taxpayer uses debt proceeds to make “an investment ex-

penditure,” the interest incurred on the debt is allocable to such investment ex-

penditure, and the interest “is treated for purposes of section 163(d) as investment

interest.” Sec. 1.163-8T(a)(4)(i)(C), Temporary Income Tax Regs., 52 Fed Reg.

25000 (July 2, 1987).

      The temporary regulations do not specify how these tracing rules apply to

partnerships and their partners. But the IRS has published guidance on this point.

See Notice 89-35, 1989-1 C.B. 675.5 It provides that, if a partnership uses debt

proceeds to fund a distribution to partners--i.e., to make debt-financed distribu-

      5
       The IRS has indicated that taxpayers may rely on the guidance provided in
Notice 89-35 for taxable years ending after December 31, 1987. See 1989-1 C.B.
at 676. The taxable years at issue ended long after that date.
                                        -14-

tions--each partner’s use of the proceeds determines whether the interest passed

through to him constitutes investment interest. Id. at 676-677. Thus, if a partner

uses the proceeds of a debt-financed distribution to acquire property that he holds

for investment, the corresponding interest expense incurred by the partnership and

passed on to him will be treated as investment interest. Ibid. In short, if a taxpay-

er uses debt proceeds to acquire an investment, the interest on that debt is invest-

ment interest regardless of whether the debt originated in a partnership.

      B.     Analysis

      Reduced to its essentials, the question before the Court is whether William

is bound to treat the interest expense passed through to him in the same manner as

Maurice. William acquired interests in the four partnerships by gift or bequest

from his father. Respondent argues that William in effect stepped into his father’s

shoes, with the supposed result that the interest, properly reported by Maurice as

investment interest, remains investment interest so long as the loans remain on the

partnerships’ books. We find no support for this theory in the statute, the regula-

tions, or the decided cases.

      Maurice received debt-financed distributions from the four partnerships. He

used the proceeds of those distributions to acquire shares of money market funds

and other assets that he held for investment. Consistently with the temporary
                                        -15-

regulation’s tracing rule, as applied to partners by Notice 89-35, supra, Maurice

treated the interest expense incurred by the partnerships and passed through to him

as “investment interest” properly reportable on Schedule A.

      William did not receive, directly or indirectly, any portion of the debt-

financed distributions that the partnerships made to Maurice in 2009 and 2012.

Nor did William use distributions from those partnerships to make “investment

expenditure[s].” See sec. 1.163-8T(a)(4)(i)(C), Temporary Income Tax Regs.,

supra. In short, the facts that caused the passed-through interest to be “investment

interest” in Maurice’s hands simply do not apply to William.

      The temporary regulations include a provision that explains how debt

should be allocated where (as here) no proceeds are disbursed to the taxpayer:

      If a taxpayer incurs or assumes a debt in consideration for the sale or
      use of property * * * or takes property subject to a debt, and no debt
      proceeds are disbursed to the taxpayer, the debt is treated for pur-
      poses of this section as if the taxpayer used an amount of the debt
      proceeds equal to the balance of the debt outstanding at such time to
      make an expenditure for such property * * * [Sec. 1.163-8T(c)(3)(ii),
      Temporary Income Tax Regs., 52 Fed. Reg. 25001 (July 2, 1987).]

      William acquired his ownership interests in the four partnerships by gift or

bequest from Maurice. He acquired those interests subject to the M&T and W&D

debts that were then on the partnerships’ books. Under the temporary regulation,
                                         -16-

William is thus treated as using his allocable share of that debt “to make an ex-

penditure for such property,” viz., his partnership interests.

      Notice 89-35 refers to this scenario as a debt-financed acquisition, as op-

posed to a debt-financed distribution, and it explains how the regulation applies to

partnerships and their partners: “In the case of debt proceeds allocated under sec-

tion 1.163-8T to the purchase of an interest in a passthrough entity (other than by

way of a contribution to the capital of the entity), the debt proceeds and the associ-

ated interest expense shall be allocated among all the assets of the entity using any

reasonable method.”

      In short, whereas Maurice received a debt-financed distribution, William is

treated as having made a debt-financed acquisition of the partnership interests he

acquired from Maurice. See ibid. For section 163(d) purposes, therefore, the debt

proceeds are allocated among all of the partnerships’ real estate assets using a

reasonable method, and the interest paid on the debt is allocated to those assets in

the same way. Sec. 1.163-8T(c)(1), Temporary Income Tax Regs., supra.

      The partnerships’ real estate assets were actively managed operating assets.

Respondent agrees that those assets did not constitute “property held for invest-

ment.” See sec. 163(d)(3)(A). The interest paid on the M&T and W&D loans

therefore was not “investment interest.”
                                           -17-

      In support of the opposite conclusion, respondent disputes the relevance of

section 1.163-8T(c)(3)(ii), Temporary Income Tax Regs., supra, urging that Wil-

liam, when acquiring the partnership interests from his father, did not “assume[] a

debt” or “take[] property subject to a debt.” Respondent agrees that the M&T and

W&D loans were bona fide liabilities of the partnerships. But he emphasizes that

William had no personal liability on those loans, which were nonrecourse, and that

the liens held by the lenders ran against the partnerships’ real estate assets, not

against William’s partnership interests.

      We find no support for respondent’s position. In Smith v. Commissioner,

84 T.C. 889 (1985), aff’d, 805 F.2d 1073 (D.C. Cir. 1986), we considered whether

a corporation should be considered to have assumed a liability for purposes of

section 357(c) where a shareholder contributed to it an interest in a partnership

whose assets were encumbered by non-recourse debt. Judge Tannenwald

answered that question in the affirmative: “Where, as here, the partnership in-

terests transferred are themselves encumbered in substance by a right of fore-

closure on the partnership’s real property, the corporation acquires such interests

subject to the encumbrance.” Smith, 84 T.C. at 910 (emphasis added) (citing

Commissioner v. Tufts, 461 U.S. 300 (1983)). The Commissioner himself had

previously reasoned similarly, ruling that, where limited partnership interests are
                                          -18-

transferred to a corporation, “[e]ach transferring limited partner’s share of partner-

ship nonrecourse liabilities shall be considered as a liability to which the partner-

ship interest is subject.” Rev. Rul. 80-323, 1980-2 C.B. 124, 125.

      These authorities show that William acquired his interests in Mar-Cal, May-

fair, Brinkley, and Claridge “subject to” the M&T and W&D debts, even though

he did not personally assume those debts, which remained nonrecourse with re-

spect to the partners individually. In the converse situation, where a partner sells a

partnership interest, the regulations provide that the partner’s “amount realized”

includes his share of the partnership liabilities of which he is relieved, even if the

liabilities are nonrecourse. See secs. 1.752-1, 1.1001-2(a)(4)(v), Income Tax

Regs.; see also sec. 1.1001-2(c), Example (4), Income Tax Regs. (stating that a

taxpayer’s “amount realized” on transfer of a partnership interest includes the non-

recourse liabilities of which he is relieved, where the transferee “takes the partner-

ship interest subject to the * * * liabilities”). For purposes of subchapter K gener-

ally, any increase or decrease in a partner’s share of partnership liabilities is treat-

ed as a deemed contribution or distribution, regardless of whether the debt is re-

course or nonrecourse. See sec. 752; sec. 1.752-1, Income Tax Regs. In short, the

fact that a partner is not personally liable for a partnership’s debt does not mean
                                         -19-

that his partnership interest is not “subject to a debt” for purposes of subchapter

K.6

      For these reasons, we conclude that section 1.163-8T(c)(3)(ii), Temporary

Income Tax Regs., supra, in conjunction with Notice 89-35, supra, dictates that the

interest expense passed through to William from the partnerships was not “invest-

ment interest” under section 163(d). But even if that temporary regulation were

somehow thought inapplicable here, respondent has not articulated any principle

or rule that would affirmatively require the interest in question to be characterized

as “investment interest.” The principle that required such interest to be character-

ized as “investment interest” in Maurice’s hands clearly does not apply because

William (unlike Maurice) did not receive any debt-financed distributions from the

partnerships.

      Respondent does not contend that William received debt-financed distri-

butions indirectly or that the substance of the parties’ transactions differed from

their form. Respondent’s position thus reduces to the contention that, because

      6
        When Maurice gratuitously transferred interests in Mar-Cal, Mayfair, and
Brinkley to William in 2011, he was required to include the partnership debt from
which he was relieved as an “amount realized,” and he reported capital gains tax
accordingly. See supra p. 6. To the extent Maurice was relieved of the debt, liabi-
lity therefore necessarily shifted to the other partners, including William. William
thus took his partnership interests “subject to the debt,” even though the liabilities
were nonrecourse.
                                          -20-

William acquired the partnership interests from his father, he stands in his father’s

shoes and must treat the passed-through interest the same way his father did. But

neither section 163(d) nor its implementing regulations include any family attribu-

tion rule or similar principle that would require this result.

      It seems obvious that William would have no “investment interest” if he had

acquired his ownership interests in the four partnerships from a third party for

cash. Respondent has not explained why the result should be different because

William acquired those interests from his father by gift and bequest. Respondent,

in short, has enunciated no principle that would justify characterizing the interest

passed through to William as “properly allocable to property held for investment”

by William. Sec. 163(d)(3)(A).

      Respondent urges us to adopt a “once investment interest, always invest-

ment interest” rule on the theory that any other approach would “place a myriad of

additional administrative burdens on both taxpayers and the government.” But the

temporary regulations and IRS guidance clearly dictate different outcomes de-

pending on whether the partner receives a debt-financed distribution or makes a

debt-financed acquisition. See sec. 1.163-8T(c)(3)(ii), Temporary Income Tax

Regs., supra; Notice 89-35, supra. Recognition that partnership interests may

change hands is thus an inherent part of the regulatory structure. And the alloca-
                                         -21-

tion is no more cumbersome than allocating debt for any other purpose under

subchapter K.

      In sum, we hold that the interest expense passed through to William from

the M&T and W&D loans was not “investment interest” under section 163(d).

When William acquired the partnership interests from his father, he was in the

same position as any other person who acquired partnership interests encumbered

by debt. He did not receive the proceeds of those debts, and he did not use (and

could not have used) the proceeds of those debts to acquire property that he subse-

quently held for investment. There is thus no justification for treating the interest

expense passed through to him as investment interest under section 163(d). Rath-

er, petitioners correctly reported it on Schedule E as allocable to the real estate as-

sets held by the partnerships. Concluding that there are no deficiencies in peti-

tioners’ income tax for 2013 and 2014, we find that they are likewise liable for no

penalties.

      To reflect the foregoing,


                                                Decision will be entered for

                                        petitioners.
