Qualified Residence Interest Limits Apply on a Per Residence Basis

By James A. Beavers, J.D., LL.M., CPA, CGMA

Expenses & Deductions

The Tax Court held that, for purposes of calculating qualified residence interest, the Sec. 163(h)(3) limits on the amount of indebtedness that qualifies as acquisition or home equity indebtedness do not apply separately to co-owners of property who are not married.

Background

In 2000 Charles J. Sophy and Bruce H. Voss purchased a house together in Rancho Mirage, Calif., and financed the purchase by obtaining a mortgage that was secured by the Rancho Mirage house. In 2002, Sophy and Voss also purchased a house in Beverly Hills, Calif., that they financed with a mortgage secured by the house. They acquired both houses as joint tenants and held them as joint tenants during the years in issue. The two used the Beverly Hills house as their principal residence and the Rancho Mirage house as their second residence.

In 2006, Sophy paid mortgage interest of $94,698 for the two residences, and Voss paid $85,962. The total average balance in 2006 for the Beverly Hills house mortgage and home equity loan and the Rancho Mirage house mortgage was $2,703,568. In 2007, Sophy paid mortgage interest of $99,901, and Voss paid $76,635. The total average balance in 2007 for the two mortgages and the home equity loan was $2,669,136. On his tax returns for 2006 and 2007, Sophy claimed deductions of $95,396 and $65,614, respectively. Voss claimed deductions of $95,396 and $88,268, respectively.

On audit, the IRS disallowed a portion of both taxpayers’ deductions for qualified residence interest for 2006 and 2007. The IRS found that the taxpayers had deducted interest on an amount of indebtedness greater than that allowed under the limits in Sec. 163(h)(3).

Sec. 163(h) and the Parties’ Arguments

Sec. 163(h)(2) makes an exception to the rule in Sec. 163(h)(1) that a taxpayer cannot deduct personal residence interest. Qualified residence interest is interest on acquisition indebtedness or home equity indebtedness with respect to a taxpayer’s qualified residence (in this case, there was no question that the residences involved were qualified residences). However, under Sec. 163(h)(3), for purposes of determining the amount of qualified residence interest, the amount of indebtedness that can be treated as acquisition indebtedness is limited to $1 million in the case of acquisition indebtedness and to $100,000 in the case of home equity indebtedness.

In its determination of the deductible qualified residence interest of Sophy and Voss for 2006 and 2007, the IRS applied the limitations on a per residence basis. Therefore, it determined that each taxpayer, as a joint owner of the houses, was entitled to a deduction for his pro-rata share of the interest the two paid on $1.1 million of the debt secured by each house. This was consistent with IRS guidance on the subject (CCA 200911007).

The taxpayers argued that the limitations apply on a per taxpayer basis for residence co-owners who are not married to each other. Thus, they should each be allowed to deduct interest on acquisition indebtedness up to $1 million and home equity indebtedness up to $100,000 with respect to each of the residences, thereby doubling the amount of qualified residence interest they could deduct.

The Tax Court’s Decision

The Tax Court held that, for purposes of calculating qualified residence interest, the limitations on the amount of indebtedness that can be considered acquisition or home equity indebtedness apply on a per residence basis. Therefore, the IRS properly disallowed each taxpayer’s deductions for the pro-rata share of the interest he paid on the qualified residence indebtedness in excess of $1.1 million.

The Tax Court looked to the statutory language in making its decision. It noted that, in the statute, the terms “acquisition indebtedness” and “home equity indebtedness” were both defined in relation to “acquiring, constructing, or substantially improving any qualified residence of the taxpayer,” and that references to “the taxpayer” in the definitions of both terms was used in relation to the qualified residence, not to the indebtedness. This led the Tax Court to conclude that the limitation on indebtedness was tied to the residence, not to the taxpayer. The Tax Court further found that the fact that the statute provided that the limitations for married taxpayers filing separately were half of those for married taxpayers filing jointly suggested that unmarried co-owners of property were subject to the same deduction limitation as married taxpayers filing jointly.

Sophy and Voss argued that, in setting out the reduced limitations for married taxpayers filing separately, Congress intended to create a special rule for married couples that does not apply to co-owners who are not married to each other. The court rejected this argument based on the residence-focused language of Sec. 163(h)(3) and the absence of any reference to an individual taxpayer in the indebtedness limitations. According to the court:

Rather than setting out a marriage penalty, this language simply appears to set out a specific allocation of the limitation amounts that must be used by married couples filing separate tax returns, thus implying that co-owners who are not married to one another may choose to allocate the limitation amounts among themselves in some other manner, such as according to percentage of ownership.


Reflections

This case highlights yet another example of a poorly written tax statute. While it cannot seriously be believed that Congress intended the interpretation of Sec. 163(h) suggested by the taxpayers, the imprecision of the statute’s language leaves an opening to make the argument. The IRS could have removed any doubt about the issue by addressing it in the temporary regulations on qualified residence interest (Temp. Regs. Sec. 1.163-10T) issued in 1987 (which are still effective because they were issued before Nov. 20, 1988), but failed to do so.

Sophy, 138 T.C. No. 8 (2012)

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