IRS Chief Counsel's Office Clarifies Rules Governing Qualified Residence Interest Deduction

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By David I. Kempler, Esq., and Elizabeth Carrott Minnigh, Esq.  

Buchanan Ingersoll & Rooney PC, Washington, DC

In CCA 201201017, the IRS Office of Chief Counsel was asked to determine to what extent the temporary regulations remain relevant to the calculation of qualified residence interest after the statutory changes under Omnibus Budget Reconciliation Act of 1987 (OBRA 1987). In response, the Chief Counsel's Office advised that a taxpayer may use any reasonable method, including exact method, to determine the amount deductible as qualified residence interest in circumstances where the debt exceeds acquisition and/or home equity debt limitations. The Chief Counsel's Office further advised that, regardless of which method was used, the taxpayer may allocate any amounts that exceed limitations in accordance with the use of debt proceeds as provided in Regs. §1.163-10T(e)(4) and the instruction to line 13 of IRS Publication 936, Home Interest Mortgage.  This memorandum resolves uncertainty regarding which methods may be used in order to allocate the interest on the part of a debt that exceeds the qualified residence interest limitations.

Although personal interest is nondeductible, §163(h)(3), as amended by OBRA 1987, permits a deduction for qualified residence interest for up to $1,000,000 of acquisition indebtedness and $100,000 of home equity indebtedness. Prior to OBRA 1987 §163(h)(3) generally permitted a deduction for qualified residence interest on indebtedness that did not exceed the basis of the residence and the cost of improvements, and on certain other indebtedness incurred for medical and educational purposes. Proposed and temporary regulations, Regs. §§1.163-9T and -10T, were issued under §163(h), shortly before the statute was amended. Portions of these regulations relating to the limitations on the qualified residence interest deduction became obsolete as a result of the amendments. After OBRA 1987, the IRS issued Notice 88-74, 1988-2 C.B. 385, to provide guidance as to certain provisions of the revised statute. Additionally, the IRS published Publication 936, Home Mortgage Interest Deduction, to provide additional guidance with respect to the deduction.

Regs. §1.163-10T provides two methods for determining a taxpayer's qualified residence interest when debt exceeds the applicable limitation: (i) a simplified method under Regs. §1.163-10T(d) and (ii) an exact method under Regs. §1.163-10T(e). The simplified method requests that interest on all secured debts be multiplied by a fraction, the numerator of which is the adjusted purchase price of the qualified residence and the denominator of which is the sum of the average balances of all secured debts. The Chief Counsel's Office concluded that, to properly reflect the OBRA 1987 amendments, the $1,000,000 acquisition indebtedness limitation and the $100,000 home equity indebtedness limitation must be substituted for the adjusted purchase price. Under Regs. §1.163-10T(d)(2), when the simplified method is used, a taxpayer is required to treat interest on all excess debt as personal interest under the temporary regulations.

Under the exact method, the amount of qualified residence interest is determined on a debt-by-debt basis by individually comparing the applicable debt limit for each debt to the average balance of each debt. The applicable debt limit is equal to the lesser of the fair market value of the residence on the date the debt was secured and the adjusted purchase price of the qualified residence at the end of the taxable year, reduced by the average balance of each debt that was previously secured by the qualified residence. If the average balance of the debt does not exceed the limitation for that debt, then all the interest on that debt is qualified residence interest.  If the average balance of the debt exceeds the limitation, then the amount of qualified residence interest must be determined by multiplying the interest paid (or accrued) with respect to the debt by a fraction, the numerator of which is the applicable debt limit for that debt and the denominator of which is the average balance of that debt.  Under the exact method, as set forth in Regs. §1.163-10T(e)(4), a taxpayer is permitted to treat interest on debt in excess of the limitations according to the use of the debt proceeds under the interest tracing rules set forth in Regs. §1.163-8T.

The House Committee Report to OBRA 1987, H.R. Rep. No. 100-391, stated as follows: "[i]t is anticipated that the Internal Revenue Service will issue regulations describing the proper method for allocating interest on excess amounts of debt.  In the interim until such regulations are issued, a reasonable method of allocation should be used. An example of a reasonable method of allocation is to ascertain which debt is the debt that exceeds the limitation by taking debt into account in the chronological order in which it was incurred or most recently refinanced, with the most recent debt (or portion thereof) treated as the amount of debt that exceeds the limit."

Publication 936, issued by the IRS after OBRA 1987 provides a worksheet for taxpayers to utilize to determine their qualified residence interest. The worksheet uses a method similar to the simplified method. However, unlike the simplified method, the instruction to line 13 of the worksheet provides that the portion of secured indebtedness that is not qualified residence interest may be allocated in accordance with the use of the proceeds of the debt as is permitted under the exact method.

The Chief Counsel's Office concluded that, because the legislative history states that until regulations are issued taxpayers may use a reasonable method of allocating debt in excess of the limitation, taxpayers may use the exact method and the simplified method described in the regulations, the method provided in Publication 936 or a reasonable approximation of those methods. Additionally, the Chief Counsel's Office advised that regardless of which reasonable method was used, a taxpayer may allocate the amounts that exceed the limitations in accordance with the use of the debt proceeds as set forth in Regs. §1.163-10T(e)(4) and the instructions to line 13 of Publication 936.

Regs. §1.163-10T(o) and Publication 936 both state that taxpayers may make an election to treat a debt that is secured by a qualified residence as not secured by a qualified residence. The election must apply to the entire indebtedness, and the election is made by reporting the interest on the return as business interest or other deductible interest rather than qualified residence interest. The Chief Counsel's Office advised that a taxpayer using any reasonable method is not required to make the election under Regs. §1.163-10T(o)(5) in order to allocate the interest on the part of the debt that exceeds the qualified residence interest limitations under Regs. §1.163-8T because the election under Regs. §1.163-10T(o)(5) applies only to the whole amount of a debt and not to a part.

Interestingly, in its analysis, the Chief Counsel's Office concluded that because the legislative history stated that only that a "reasonable method" must be used, that taxpayers were not limited to the methods set forth in the temporary regulations issued previously but could also take advantage of the method set forth in an IRS publication. Accordingly, this memorandum seems to have the effect of allowing Publication 936 to modify the temporary regulations. However, importantly, the memorandum resolves uncertainty regarding which methods may be used in order to allocate the interest on the part of a debt that exceeds the qualified residence interest limitations.

 For more information, in the Tax Management Portfolios, see Daher and Aceves, 536 T.M., Interest Expense Deductions, and in Tax Practice Series, see ¶2330, Interest Expense.