IRS Agrees That Mortgage Interest Deduction Limit Applies on Per-Taxpayer Basis

Unmarried taxpayers who co-own a home are each entitled to deduct mortgage interest on $1.1 million of acquisition and home-equity indebtedness after the IRS acquiesced in the Ninth Circuit’s decision in Voss, 796 F.3d 1051 (9th Cir. 2015). The Ninth Circuit, in reversing the Tax Court’s decision in Sophy, 138 T.C. 204 (2012), concluded that the mortgage interest limitation is meant to apply on a “per-taxpayer” basis, rather than on a “per-residence” basis.

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 purchased a house together in Beverly Hills, Calif., which they financed with a mortgage secured by the Beverly Hills house. They acquired both houses as joint tenants and held them as joint tenants during the years in issue. They used the Beverly Hills house as their principal residence and the Rancho Mirage house as their second residence.

In 2006, Sophy and Voss paid mortgage interest of $94,698 and $85,962, respectively, and in 2007 paid $99,901 and $76,635, respectively. The total average balances during 2006 and 2007 of the Beverly Hills mortgage and home-equity loan and the Rancho Mirage mortgage were $2,703,568 and $2,669,136, respectively. Sophy claimed deductions for qualified residence interest on his 2006 and 2007 federal income tax returns of $95,396 and $65,614, respectively. Voss claimed deductions of $95,396 and $88,268 on his 2006 and 2007 tax returns, respectively.

The IRS audited their 2006 and 2007 individual income tax returns and disallowed portions of their deductions for mortgage interest asserting that their deductions exceeded the limits provided by the Internal Revenue Code.

IRS Wins in Tax Court

In denying a portion of Sophy’s and Voss’s mortgage interest deduction, the IRS’s argument focused on its interpretation of the acquisition indebtedness limitation that is found in Sec. 163(h)(3). The general rule under Sec. 163(h)(1) is that no deduction is allowed for the payment of personal interest. However, Sec. 163(h)(2) provides an exception for “qualified residence interest,” as defined in Sec. 163(h)(3).

Qualified residence interest is any interest that is paid or accrued during the tax year on “acquisition” or “home equity” indebtedness with respect to a qualified residence. Acquisition indebtedness is defined as any indebtedness that is incurred in acquiring, constructing, or substantially improving any qualified residence and is secured by such residence. The amount that a taxpayer can treat as acquisition indebtedness is subject to limitation. The aggregate amount that can be treated as acquisition indebtedness for any period cannot exceed $1 million (reduced to $500,000 in the case of a married individual filing a separate return).

Home-equity indebtedness is defined as any indebtedness (other than acquisition indebtedness) that is secured by a qualified residence to the extent the aggregate amount of such indebtedness does not exceed the value of the residence reduced by the amount of acquisition indebtedness. The amount the taxpayer can treat as home-equity indebtedness is also limited. The aggregate amount that can be treated as home-equity indebtedness for any period cannot exceed $100,000 (reduced to $50,000 in the case ofa separate return by a married individual).

The IRS acknowledged that both homes met the definition of a qualified residence and that the mortgage interest paid by Sophy and Voss was qualified residence interest since they paid it on acquisition and home-equity indebtedness secured by the homes.

The sole point of contention was whether the indebtedness limitations outlined in Sec. 163(h)(3) should be applied on a “per-residence” basis or on a “per-taxpayer” basis. The IRS’s interpretation of the statute (following its reasoning in Chief Counsel Advice 200911007) was that the limitations should be applied on a “per-residence” basis. Under this rationale, the IRS determined that each taxpayer, as a joint owner of the houses, was entitled to a deduction for his pro rata share of the interest he paid on $1.1 million of debt secured by each house. On the other hand, Sophy and Voss argued that the limitations should be applied on a “per-taxpayer” basis and, since Sophy and Voss filed as single taxpayers, they should each be able to claim interest deductions on $1.1 million of debt, for an aggregate amount of acquisition and home-equity indebtedness of $2.2 million.

In deciding in favor of the IRS, the Tax Court, in 2012, based its analysis on the statute’s repeated use of the phrases “with respect to any qualified residence” and “with respect to such residence” contained in the definition of “qualified residence interest” under Sec. 163(h)(3), concluding that in drafting the statute, Congress was “residence focused” rather than “taxpayer focused.” The court reasoned that the parenthetical language in the statute, which reduces the limitations on acquisition and home-equity indebtedness to $500,000 and $50,000, respectively, for married individuals filing separate returns, implies, “without expressly stating,” that married co-owners are limited to $1.1 million of aggregate acquisition and home-equity indebtedness.

Sophy and Voss argued that the provisions for married co-owners filing separately was Congress’s attempt to create a “marriage penalty” and should not apply to unmarried co-owners. However, since the Tax Court already came to its “per-residence” conclusion based on all of the “residence-focused” language in the statute with no other reference to an individual taxpayer, this argument did not sway the court. It stated the language addressing married co-owners appeared to specify an allocation method for married individuals filing separate returns whereas unmarried co-owners are free to choose their own method of allocating the limitation amounts (e.g., based on relative ownership percentage).

Ninth Circuit Weighs In

In August 2015, the Ninth Circuit, acknowledging the complexity of Sec. 163 saying, “it requires attention to definitions within definitions and exceptions upon exceptions,” came to a different interpretation of the statute. Referring to the debt limit provisions in Sec. 163(h)(3), the court stated, “[a]lthough the statute is silent as to unmarried co-owners, we infer from the statute’s treatment of married individuals filing separate returns that [Sec.] 163(h)(3)’s debt limits apply to unmarried co-owners on a per-taxpayer basis.” In coming to this conclusion, the Ninth Circuit emphasized the language Congress placed in the parenthetical of Sec. 163(h)(3) that provides different debt limits for married taxpayers filing separately. The court stated, “Congress’s use of the phrase ‘in the case of’ is important. It suggests, first, that the parentheticals contain an exception to the general debt limit set out in the main clause, not an illustration of how that general debt limit should be applied.” In the Ninth Circuit’s view, if Congress was clearly “residence-focused,” it could have simply drafted the language in the parenthetical to read “in the case of any qualified residence of a married individual filing a separate return.”

Interestingly, the court also reasoned that the parenthetical language not only is expressed in per-taxpayer terms, but actually operates in a per-taxpayer manner. In support of its analysis, the court added that the parentheticals give each separately filing spouse a separate debt limit of $550,000 so that when combined the two spouses would be entitled to a $1.1 million debt limit, which is the amount allowed a single taxpayer. If the limitation were in fact applied on a per-residence basis, any additional language imposing a one-half limitation on married couples who file separately would be superfluous. However, if the $1.1 million limitation is applied on a per-taxpayer basis, the limiting language does serve a purpose, as it prevents married couples who file separately from deducting interest on $2.2 million of debt, thereby obtaining twice the benefit of a married couple who file jointly.

IRS Recants

The IRS issued Action on Decision 2016-02 in August indicating it will follow the Ninth Circuit’s lead in applying the Secs. 163(h)(2) and (3) limitations on a per-taxpayer basis, thereby allowing each unmarried taxpayer to deduct interest on up to $1.1 million of debt on a qualified residence.

Reflections

The controversy in this case highlights another example of the complexity inherent in the Code as pointed out by the Ninth Circuit, where very smart people can interpret a less than clearly written tax statute with dramatically different results. While recent Supreme Court rulings and the ensuing issuance of Treasury regulations that require legally married same-sex couples to file as married couples will lessen the impact of the IRS’s acceptance of the Ninth Circuit’s ruling, the Service’s acquiescence provides a welcome gift to unmarried taxpayers who co-own a home.

Action on Decision 2016-02