Funds borrowed to purchase an interest in a pass-through entity are deducted in accordance with the tracing rules of Regulation 1.163-8T, Notice 89-35 and Notice 88-37.
If you are a material participant in the activity, then the interest expense you incur would be deductible on Schedule E. The amount should be reflected on a separate line on Schedule E titled "Business Interest".
If you are a passive participant in the activity, then the interest expense would be included as additional loss for this passive activity and reflected on the 8582.
The above are the general rules. If the activity has investments of its own, then you would have additional tracing requirements and the interest expense would be allocated based on any reasonable method. As an example, if you were a material participant in the activity and the activity had 5% of their assets invested in stocks (excess cash invested), then 95% of your interest expense could be reflected on Sch E as noted above. The other 5% would be considered investment interest expense reflected on form 4952.
*A reminder that posts in a forum such as this do not constitute tax advice.
Also keep in mind the date of replies, as tax law changes.
