By Anthony P. Curatola, Ph.D
Section 163(h) of the Internal Revenue Code (IRC) provides, in part, that no deduction shall be allowed for personal interest paid or accrued during the taxable year by a taxpayer other than a corporation (i.e., an individual taxpayer). Thus, individual taxpayers can’t deduct interest paid on their credit cards, auto loans, or personal loans, to name a few. But there are exceptions to the rule that make some interest deductible for an individual. Specifically, interest associated with a trade or business, investment interest, qualified residence interest, and educational interest all fall into the deductible category with certain limitations.
Qualified Residence Interest
Qualified residence interest is any interest paid or accrued during the tax year for (1) any debt related to acquiring, constructing, or substantially improving a “qualified residence” and secured by that residence or (2) home equity indebtedness with respect to any “qualified residence” of the taxpayer.
The term “qualified residence” is defined in IRC §163(h)(4) to mean a taxpayer’s principal residence and one other residence selected by the taxpayer. In the case of married individuals filing separately, the couple is treated as one person. Each person is entitled to take into account one residence unless both spouses’ consent in writing to allow one of the spouses to take into account the principal residence and one other residence.
The aggregate amount of debt treated as acquisition indebtedness shall not exceed $1 million ($500,000 in the case of a married couple filing separately). In addition, as an individual pays off the principal balance on the acquisition indebtedness, any refinancing or new debt on the residence is limited to the current balance unless the debt in excess of the current balance is incurred as a result of substantial improvement to the taxpayer’s qualified residence. In this case, the acquisition indebtedness amount is increased to reflect the current balance plus the amount associated with the improvement.
Home equity indebtedness, on the other hand, is limited to $100,000 ($50,000 in the case of a married couple filing separately), but the amount can’t exceed the fair market value of the residence less the amount of acquisition indebtedness on that residence. Unlike acquisition indebtedness, the interest remains deductible as the home equity indebtedness balance fluctuates over time within the $100,000 limit range.
Unmarried Co-Owners
A question that recently arose is how unmarried co-owners of a qualified residence deal with the residential interest deduction. Up till now, the IRS held that the acquisition indebtedness and home equity indebtedness are limited to the residences owned by the unmarried individuals and, therefore, the amount is prorated between the individuals based on their ownership interest. Put another way, the indebtedness limits are applied on a per-residence and not a per-owner basis.
For example, John and Mary, who aren’t married, purchase a home together with a market value of $3 million by taking out a mortgage for $2.5 million. The mortgage is secured by the property, and John and Mary are jointly and severally liable for the mortgage. Assume the interest they pay for the current tax year is $100,000.
Under the IRS’s position, John and Mary would be entitled to deduct $40,000 ($100,000 × ($1 million / $2.5 million)) as acquisition indebtedness, which would be split equally (i.e., $20,000 each). In addition, John and Mary would be able to deduct $4,000 ($100,000 × ($100,000 / $2.5 million)) as home equity indebtedness. That also would be split equally (i.e., $2,000 for each of them). In total, the two could deduct $44,000 of the $100,000 interest payment, which is the same as a married couple’s deduction.
But in a majority decision in Voss v. Commissioner and Sophy v. Commissioner 2015-2 USTC ¶50,427 (August 7, 2015), the Ninth Circuit Court ruled that the indebtedness limits are applied on a per-owner and not a per-residence basis. This overturned the previously ruling of the Tax Court in Sophy v. Commissioner and Voss v. Commissioner 138 T.C. No. 8 and 138 T.C. No. 204 (March 5, 2012), which had ruled that the limitations on the amounts that may be treated as acquisition and home equity indebtedness with respect to a qualified residence are properly applied on a per-residence basis. The majority of the Ninth Circuit justices reached their different conclusion in part on the legislative wording in the Internal Revenue Code. Specifically, they state:
“The parentheticals clearly speak in per-taxpayer terms: the limit on acquisition indebtedness is ‘$500,000 in the case of a married individual filing a separate return,’ and the limit on home equity indebtedness is ‘$50,000 in the case of a separate return by a married individual’…Had Congress wanted to draft the parentheticals in per-residence terms, doing so would not have been particularly difficult. Congress could have written, ‘in the case of any qualified residence of a married individual filing a separate return.’ Yet, once again, Congress did not draft the statute in that way. The per-taxpayer wording of the parentheticals…thus suggests that the wording of the main clause—in particular, the phrase ‘aggregate amount treated’—should likewise be understood in a per-taxpayer manner.”
The majority also held that the parentheticals for a married couple give each separately filing spouse a separate debt limit of $550,000 so that, together, the two spouses are effectively entitled to a $1.1 million debt limit (the normal limit for single taxpayers). As a result, they feel the statute clearly intended the limits to apply on a per-taxpayer basis.
The Dissenting Opinion
As noted by the dissenting judge in this opinion, the majority interprets the tax code to allow unmarried taxpayers who buy an expensive residence together to deduct twice the amount of interest paid on the debt secured by their residence than spouses would be allowed to deduct. As a result of this decision, unmarried individuals enjoy a windfall deduction that is questionable.
Returning to our example, the Ninth Circuit’s holding provides John and Mary with an interest deduction of $80,000 ($100,000 × ($2 million / $2.5 million)) of the $100,000 on acquisition indebtedness, which would be split equally (i.e., $40,000) between the two of them. In addition, John and Mary would be able to deduct $8,000 ($100,000 × ($200,000 / $2.5 million)) on home equity indebtedness, which would be split equally (i.e., $4,000 each). In total, John and Mary could deduct $88,000 of the $100,000 interest payment, which is twice a married couple’s deduction.
Impact of the Ruling
There are a few interesting issues to point out from this decision. First, the majority justices acknowledge their interpretation of the debt limit provision results in a marriage penalty, but “they are not particularly troubled” by that. Second, if property is acquired by more than two individuals, then one must assume that the indebtedness limits applies to each owner from this ruling. Third, and most important, this ruling is applicable to the Ninth Circuit, which includes Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, Washington, Northern Mariana Islands, and Guam. It’s unclear whether or not other circuits will follow the Ninth Circuit, which means that the Tax Court’s opinion—although a lower court in the Ninth Circuit—will have precedence for the rest of the United States for the moment.
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© 2016 A.P. Curatola
Anthony P. Curatola, Ph.D., is the Joseph F. Ford Professor of Accounting at Drexel University in Philadelphia, PA., a tax columnist, and an author of the EA Exam Review for Surgent Professional Education. Tony can be reached at curatola@drexel.edu.
The author herby authorizes the use of this article by TaxAct in their upcoming e-newsletter while Tony Curatola retains all rights and privileges to the article