Rental Prop Loan continues after sale - deduct interest?

Taxpayer is made a bad investment in a rental property. Paid $1000k for a piece of property and was only able to recoup half back. He owed $800k. after the sale he still owes $300k. Can the taxpayer continue to write off the interest expense on Schedule E? How does this affect passive activity losses?

It's a good question. I'm guessing it gets reallocated to personal by virtue of 1.163-8T, but I am definitely guessing and can't wait to hear the right answer.

(j) Reallocation of debt -

(1) Debt allocated to capital expenditures -

(i) Time of reallocation. Except as provided in paragraph (j)(2) of this section, debt allocated to an expenditure properly chargeable to capital account with respect to an asset (the “first expenditure”) is reallocated to another expenditure on the earlier of -

(A) The date on which proceeds from a disposition of such asset are used for another expenditure; or

(B) The date on which the character of the first expenditure changes (e.g., from a passive activity expenditure to an expenditure that is not a passive activity expenditure) by reason of a change in the use of the asset with respect to which the first expenditure was capitalized.

No change with asset, asset is gone (no capital asset to reallocate the interest to). Interest expense should be deductible as non-passive loss, IMO (it was incurred with respect to a rental activity which was entirely disposed of).

A very logical answer.

Investment interest expense now? Tho' he won't have enough income to offset it.

Can the taxpayer continue to write off the interest expense on Schedule E?

I am just impressed that this taxpayer is continuing to pay this debt...it seems that every underwater client I've encountered simply blames everyone or everything else for their situation and demands that the bank eat their misfortune.

I actually had one client (very wealthy, high earner) who was about $600,000 underwater on a real estate investment from the 2007-2008 downturn. Rather than pay the bank when they wouldn't agree to forgive the debt in a short sale, he proceeded to pay $50,000 to a consultant to setup a convoluted structure of entities and trusts to hold all of his assets, which then required about $25,000 of annual fees to maintain the entities and prepare all of the tax filings. I did not work on his taxes after that.

Investment interest expense now?. What investment?

HenryDavid's reasoning seems to fit right in to the excerpted reg. Or does it?

The reallocation happens on the earlier of:
The date when the proceeds are used for another expenditure. I'd say that did not happen. They were used to buy a rental property which, after sale, left no proceeds to reinvest and therefore reallocate.
The date on which the character of the first expenditure changes by a change in the use of the asset to which the debt was first allocated. That was actually my basis for my conclusion that it became personal interest. But there's no longer an asset to reallocate to.

This below surely supports HenryDavid, right?

(B) Interest expense allocated to a passive activity expenditure (as defined in paragraph (b)(4) of this section) or a former passive activity expenditure (as defined in paragraph (b)(2) of this section) is taken into account for purposes of section 469 in determining the income or loss from the activity to which such expenditure relates;

(2) “Former passive activity expenditure” means an expenditure that is taken into account under section 469 in computing the income or loss from a former passive activity of the taxpayer or an expenditure (including an expenditure properly chargeable to capital account) that would be so taken into account if such expenditure were otherwise deductible.

The discussion started with Reg § 1.163-8T(j)(1)(ii). Checkpoint has an article that gives the example of a debt against a vehicle that was converted from business to personal. A portion of the debt is still considered business due to the reallocation based on fmv at the time of change in use from business to personal. The interest on this portion of the debt continues to be treated as business interest expense but this was just an RIA observation and there was no link to an actual code section. Hence, I asked the question. HenryDavid's reasoning makes sense and gels with what checkpoint suggests but needed a second opinion. You can't know everything!

Taxpayer is made a bad investment in a rental property. Paid $1000k for a piece of property and was only able to recoup half back. He owed $800k. after the sale he still owes $300k. Can the taxpayer continue to write off the interest expense on Schedule E? How does this affect passive activity losses?

Sorry for the typo: Taxpayer made a bad investment*

Investment interest expense now?. What investment?

HenryDavid's reasoning seems to fit right in to the excerpted reg. Or does it?

The reallocation happens on the earlier of:
The date when the proceeds are used for another expenditure. I'd say that did not happen. They were used to buy a rental property which, after sale, left no proceeds to reinvest and therefore reallocate.
The date on which the character of the first expenditure changes by a change in the use of the asset to which the debt was first allocated. That was actually my basis for my conclusion that it became personal interest. But there's no longer an asset to reallocate to.

This below surely supports HenryDavid, right?

(B) Interest expense allocated to a passive activity expenditure (as defined in paragraph (b)(4) of this section) or a former passive activity expenditure (as defined in paragraph (b)(2) of this section) is taken into account for purposes of section 469 in determining the income or loss from the activity to which such expenditure relates;

(2) “Former passive activity expenditure” means an expenditure that is taken into account under section 469 in computing the income or loss from a former passive activity of the taxpayer or an expenditure (including an expenditure properly chargeable to capital account) that would be so taken into account if such expenditure were otherwise deductible.

Former passive activity losses are allowed up to nonpassive income with the remaining treated as a pal carryforward. I think that's what you're referring to?

If this is the case, then the taxpayer cannot deduct the interest currently but will be carried forward as a PAL carryforward. The activity has no current income therefore it's not considered nonpassive?

But there was a complete disposition of the asset, so that makes me think the losses are freed up? Will have to research this side more...

Update: 469(g) is clear as it makes reference to a former passive activity. All losses are treated as a loss from not a passive activity.

Methinks we have a bit of circular reasoning happening here. How can the interest after a complete disposition be part of a loss from a former passive activity?

The statutory def'n is:

(3) Former passive activity The term “former passive activity” means any activity which, with respect to the taxpayer—
(A) is not a passive activity for the taxable year, but
(B) was a passive activity for any prior taxable year.

Doesn't that mean there has to still be an activity w/respect to the taxpayer? If it's disposed of, it's not. Stated slightly differently, he could not have completely disposed of the activity (and claimed the loss) if he still has expenses allocated to the activity. It'd be different if he changed the property to personal use. He'd still have the property and his activity would be personal.

(g) Dispositions of entire interest in passive activityIf during the taxable year a taxpayer disposes of his entire interest in any passive activity (or former passive activity), the following rules shall apply:
(1) Fully taxable transaction
(A) In generalIf all gain or loss realized on such disposition is recognized,

The interest is not a loss realized on disposition. It;s not even incurred at that point (nor paid).

I think I'm back to my conclusion that I was first inclined to; it's personal interest. Maybe.

Don’t see how it could be personal. Could argue that the activity wasn’t disposed of (I’m not suggesting that based on the facts), and treat as PAL if that was the case, but still isn’t personal...was incurred with respect to a (trade or business) activity

Isn’t all that rare for bad real estate deals to not get all the debt forgiven, and the participants to continue paying interest for years to come

Stumbled across this other discussion from 2016. It made me think about this discussion here:

Deducting business expenses after business closed