The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By Christine B. Bowers, Esq.
Buchanan Ingersoll & Rooney PC, Washington, D.C.
Under §163,1 a taxpayer may deduct the interest paid on a mortgage or home equity line of credit for a principal residence and a second home. The deduction is limited, however, to interest paid on $1 million of mortgage debt and $100,000 of home equity debt.2 If the taxpayer is married filing a separate return, the debt limit is $550,000. If the taxpayer's home indebtedness exceeds $1.1 million, then only a portion of the interest may be deducted, determined by the ratio of the statutory debt limit divided by the total actual debt.3 In Voss v. Commissioner,4 the U.S. Court of Appeals for the Ninth Circuit reversed the Tax Court and held that in the case of unmarried co-owners of a qualified residence, the debt limit provisions apply on a per-taxpayer basis rather than on a per-residence basis in determining the amount of the allowable interest deduction under §163(h).
Taxpayers were Bruce Voss and Charles Sophy, who were domestic partners registered with the State of California. Taxpayers co-owned two homes as joint tenants, with a $2,000,000 mortgage and $300,000 home equity line of credit secured by their primary residence and a $500,000 mortgage secured by the second home. Taxpayers were each jointly and severally liable for the mortgages and the line of credit. The total average balance of the two mortgages and the line of credit was $2,703,568.05 in 2006 and $2,669,135.57 in 2007, and the total mortgage interest paid was $180,660.63 in 2006 and $176,536.43 in 2007, which made the $1,100,000 debt limit relevant to their tax liabilities. Taxpayers each filed separate federal income tax returns for 2006 and 2007 on which they claimed home mortgage interest deductions for interest paid on the two mortgages and the home equity line of credit. Mr. Voss claimed deductions of $95,396 and $88,268 for 2006 and 2007, respectively, and Mr. Sophy claimed deductions of $95,396 and $65,614 for 2006 and 2007, respectively.
The IRS audited the 2006 and 2007 returns and assessed notices of deficiency to Taxpayers. The IRS calculated each of Taxpayer's mortgage interest deduction by applying a limitation ratio to the total amount of mortgage interest that each petitioner paid in each taxable year. The limitation ratio was the same for both Taxpayers, $1.1 million ($1 million of home acquisition debt plus $100,000 of home equity debt) over the entire average balance, for each taxable year, for both mortgages and the home equity line of credit. The IRS concluded that Mr. Voss was allowed to deduct $34,975 in 2006 and $31,583 in 2007 and Mr. Sophy was allowed to deduct $38,530 in 2006 and $41,171 in 2007. Thus, the IRS disallowed $60,421 and $56,685 of Mr. Voss's claimed deductions in 2006 and 2007, respectively, and $56,866 and $24,443 of Mr. Sophy's claimed deductions in 2006 and 2007, respectively. Taxpayers filed petitions with the Tax Court and the cases were consolidated and submitted for decision without trial on the basis of the stipulated facts. The issue addressed by both the Tax Court and the Ninth Circuit was whether the statutory limitations on the amount of acquisition and home equity indebtedness with respect to which interest is deductible under §163(h) are properly applied on a per-residence or per-taxpayer basis when residence co-owners are not married to each other.
The Ninth Circuit began its analysis by explaining that if the interest deduction limitations apply, both Mr. Voss and Mr. Sophy are entitled to a $1.1 million debt limit, such that together they can deduct interest payments up to $2.2 million of acquisition and home equity debt, but if the debt limit provisions apply per residence, as the Tax Court held, then the $1 million and $100,000 debt limits must be divided up in some way between Mr. Voss and Mr. Sophy. Examining the text of the statute, which provides that "[t]he aggregate amount treated as acquisition indebtedness for any period shall not exceed $1,000,000 ($500,000 in the case of a married individual filing a separate return)" and "[t]he aggregate amount treated as home equity indebtedness for any period shall not exceed $100,000 ($50,000 in the case of a separate return by a married individual)," the Ninth Circuit stated that the parenthetical language offered at least three useful insights for interpreting the general debt limit provisions in the main clauses.
First, the Ninth Circuit concluded that the parentheticals clearly speak in per-taxpayer terms given their references to a "married individual," even though married individuals usually co-own their homes and are jointly and severally liable on any mortgage debt. The Ninth Circuit stated that had Congress wanted to draft the parentheticals in per-residence terms, it could have easily written, "in the case of any qualified residence of a married individual filing a separate return [emphasis added]," yet it did not draft the statute in that way. The Ninth Circuit concluded that the per-taxpayer wording of the parentheticals, considered in light of the parentheticals' use of the phrase "in the case of," suggested that the wording of the main clause, "aggregate amount treated," should likewise be understood in a per-taxpayer manner.
Second, the Ninth Circuit concluded that the parentheticals did not only speak in per-taxpayer terms but they operated in a per-taxpayer manner because they gave each 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, and they did not subject both spouses jointly to the $550,000 debt limit. The Ninth Circuit reasoned that under a per-residence reading, the parentheticals would subject both spouses jointly to the $550,000 debt limit, which would result in a separately filing couple having a $550,000 debt limit, whereas the jointly filing couple and even the single individual would have a $1.1 million debt limit. In the Ninth Circuit's view, this was not what the statute intended. The Ninth Circuit stated that if the debt limits for spouses filing separately applied per spouse, there was no reason in the statute why the debt limits for unmarried individuals should not apply per unmarried individual. Thus, the Ninth Circuit concluded that the per-taxpayer operation of the debt limits for married individuals filing separately suggested that the general debt limits also operated per taxpayer.
Third, the Ninth Circuit concluded that the very inclusion of the parentheticals suggested that the debt limits applied on a per-taxpayer basis. The Ninth Circuit stated that if the $1.1 million debt limit truly applied per residence, as the Tax Court held, the parentheticals would be superfluous, as there would be no need to provide that two spouses filing separately get $550,000 each and that in contrast, if the $1.1 million debt limit applied per taxpayer, the parentheticals actually do something in that they give each separately filing spouse half the debt limit so that the separately filing couple is, as a unit, subject to the same debt limit as a jointly filing couple.
The Ninth Circuit rejected the Tax Court's interpretation of the parentheticals, which was that they set forth a specific allocation of the limitation amounts that must be used by married couples filing separately and implied that co-owners who are not married to one another may choose to allocate the limitation amounts themselves in some other manner, such as by percentage of ownership. The Ninth Circuit thought that the more likely intent of the parentheticals was to ensure that married couples filing a separate return are treated the same for purposes of §163(h)(3) as married couples filing a joint return or, in other words, to ensure that all married couples, not just joint filers, are treated as though they were a single taxpayer. To support its position, the Ninth Circuit pointed out various other provisions, such as §22(c)(2)(A) elderly and disabled credit, §1202(b) small business stock gain exclusion and §1211(b) capital loss limitation, in which Congress has provided for "half-sized deductions, credits, or limits for separately filing spouses," stating that the intent of these provisions was not to prevent separately filing spouses from allocating the benefit but to ensure that the separately filing spouses do not get double the credit, the exclusion, the losses, or the debt limit that the jointly filing couple gets. The Ninth Circuit stated, further, that if Congress wanted to ensure that two or more unmarried taxpayers are treated as a single taxpayer for purposes of a particular deduction or credit, it could have done so, as it did with the first-time homebuyer credit of §36, which provides that "In the case of a married individual filing a separate return, subparagraph (A) [the provision containing an $8,000 cap] shall be applied by substituting "$4,000" for "$8,000" and that "[i]f two or more individuals who are not married purchase a principal residence, the amount of the credit allowed … shall be allocated among such individuals in such manner as the Secretary may prescribe, except that the total amount of the credits allowed to all such individuals shall not exceed $8,000." In the Ninth Circuit's view, this demonstrated that Congress knew how to treat a group of unmarried taxpayers as a single taxpayer for purposes of a particular tax benefit or burden but did not do so in the case of §163(h). The Ninth Circuit concluded, therefore, that the married-person parentheticals' language, purpose, and operation all strongly suggested that §163(h)(3)'s debt limit provisions apply per taxpayer, not per residence.
According to the Ninth Circuit, two provisions of §163(h) were at odds with the Tax Court's per-residence interpretation of the statute. In the Ninth Circuit's view the repeated references to a single "taxable year" in §163(h) implied that the debt limits applies on a per-taxpayer basis, as residences obviously did not have taxable years. The Ninth Circuit also looked to the definition of "qualified residence," which generally includes a principal residence and one other residence, and stated that it was difficult to reconcile this definition with a per-residence interpretation because it could result in one co-owner's deduction depending on the size of another co-owner's mortgage on a home in which the first co-owner has no interest (e.g., where two individuals have separate primary residences but go in together on a vacation home) and require co-owners to coordinate their tax returns to ensure that the aggregate amount of acquisition debt for each co-owner's qualified residence did not exceed $1 million.
In reaching its decision, the Ninth Circuit refused to defer to CCA 200911007, which analyzed the application of the acquisition indebtedness limitation where the total acquisition indebtedness exceeded $1 million and the residence was owned by two unmarried co-owners. The Ninth Circuit concluded that the CCA should only be given limited weight because its analysis was neither thorough nor exhaustive.
The Ninth Circuit agreed with the IRS that the debt limit provisions of §163(h)(3) resulted in a marriage penalty but stated that it was not particularly troubled by this, stating that "Congress may very well have good reasons for allowing that result, and, in any event, Congress clearly singled out married couples for specific treatment when it explicitly provided lower debt limits for married couples yet, for whatever reason, did not similarly provide lower debt limits for unmarried co-owners." Conversely, the dissenting opinion concluded that the majority's opinion resulted in a windfall to unmarried taxpayers and argued that since the statute was ambiguous the courts should defer to the IRS's interpretation.
For now, unmarried, co-owner taxpayers in the Ninth Circuit may now safely deduct interest under the per-taxpayer approach. However, unless the IRS acquiesces on the decision, similarly situated taxpayers in other circuits may invite IRS scrutiny if adopting this approach. Accordingly, tax advisors in these other circuits may be called upon to help unmarried, co-owner clients analyze the risks and rewards of deducting interest under the per-taxpayer approach.
For more information, in the Tax Management Portfolios, see Edwards, 594 T.M., Tax Implications of Home Ownership, and in Tax Practice Series, see ¶2330, Interest Expense.
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