This monthly journal offers the latest insights in the crucial areas of real estate tax planning, including passive loss rules, tax-free exchanges, workouts, REMICS and REITs. It includes analytical articles, practitioners’ comments, and analysis of recent developments.
By David I. Kempler, Esq., and Elizabeth Carrott Minnigh, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
In Sophy v. Comr.,1 the Tax Court held that the limitations on home mortgage debt for purposes of determining deductible interest expense must be applied on a per-residence, rather than a per-taxpayer, basis, even where the co-owners were unmarried. The decision in this case treats unmarried co-owners of residential real property in the same manner as married co-owners that file separate returns.
A deduction is allowed for interest paid or accrued during the year on "acquisition indebtedness" or "home equity indebtedness" secured by any qualified residence of a taxpayer.2 For purposes of this deduction, a taxpayer may have up to two "qualified residences," a principal residence and one other house used by the taxpayer as a personal residence.3 "Acquisition indebtedness" is any indebtedness incurred in acquiring, constructing or substantially improving a qualified residence that is secured by the residence.4 The maximum amount of acquisition indebtedness that can be deducted is $1 million.5 "Home equity indebtedness" is any indebtedness secured by a qualified residence (other than acquisition indebtedness), to the extent of the excess of the fair market value of the qualified residence over the amount of the acquisition indebtedness thereon.6 The maximum amount of home equity indebtedness that can be deducted is $100,000.7
Sophy and Voss, an unmarried couple, jointly purchased a primary residence in Beverly Hills, California and a vacation home in Rancho Mirage, California. During the two years at issue, the outstanding mortgage principal balances for the two houses was approximately $2.7 million, and the outstanding principal balance on a joint home equity loan was approximately $300,000. On their respective federal income tax returns both years, Sophy and Voss each claimed interest deductions for acquisition indebtedness in the amount of $1 million in connection with the mortgage balances and home equity indebtedness in the amount of $100,000 with respect to the home equity loan balance. Citing CCA 200911007, the IRS sent deficiency notices to both Sophy and Voss, disallowing a substantial portion of their interest deductions on the grounds that the $1 million and $100,000 caps were applied per residence, not per taxpayer. Sophy and Voss challenged the deficiency, arguing that as unmarried taxpayers each should be allowed a deduction for interest paid on up to $1.1 million of acquisition and home equity indebtedness with respect to the residences that they jointly owned.
In CCA 200911007, the Chief Counsel's Office advised that the $1 million limitation on the deduction of mortgage interest on acquisition indebtedness applied on a per-mortgage basis, rather than on a per-taxpayer basis, where taxpayers were unmarried co-owners. The Chief Counsel's Office further reasoned that the interest deductible by the taxpayer should be determined by multiplying the amount of interest paid by taxpayer a fraction of $1 million over the amount of mortgage outstanding.
In affirming the IRS, the Tax Court focused on a literal interpretation of the statutory definitions of acquisition indebtedness and home equity indebtedness in §163(h)(3)(B)(i) and (C)(i). The Tax Court concluded that, because the acquisition indebtedness definition used the phrase "any indebtedness which is incurred" in conjunction with "acquiring, constructing, or substantially improving any qualified residence of the taxpayer and is secured by such residence," that the word "taxpayer" was used only in relation to the qualified residence, not the indebtedness. Similarly, the Tax Court noted that home equity indebtedness is defined as "any indebtedness" that is secured by a qualified residence other than acquisition indebtedness, and is not qualified by language relating to an individual taxpayer. The Tax Court concluded that because Congress used "any indebtedness" in the definitions without any qualification by language regarding an individual taxpayer, the limitations applied to the entire amount of indebtedness with respect to the residence itself.
The Tax Court further noted that parenthetical language in the definitions of acquisition indebtedness and home equity indebtedness made it clear that married taxpayers who file separate returns are limited to one-half of the otherwise allowable amount of acquisition indebtedness and home equity indebtedness. The Tax Court reasoned that the language used in these parentheticals suggest, without expressly stating, that unmarried co-owners should be similarly limited to their pro rata share of acquisition indebtedness and home equity indebtedness. Moreover, the Tax Court rejected the argument made by Sophy and Voss that the parenthetical language was meant as a "marriage penalty."
Accordingly, the Tax Court concluded that the limitations in §163(h)(3)(B)(ii) and (C)(ii) on the amounts that may be treated as acquisition indebtedness and home equity indebtedness with respect to a qualified residence are properly applied on a per-residence, not per-taxpayer, basis, regardless of the relationship of the taxpayers. If the Tax Court had found for the taxpayers in this instance it would have resulted in a more favorable tax treatment for properties owned by same-sex or other unmarried couples than permitted for heterosexual married couples.
Before CCA 200911007, many tax professionals took the position that if a same sex or unmarried couple owned a primary home or two jointly, each could separately deduct the interest paid on up to $1.1 million worth of mortgage debt. After CCA 200911007, some taxpayers continued to claim deductions on a per-taxpayer basis, since the CCA was non-binding authority. The decision in Sophy essentially forecloses the possibility for unmarried taxpayers to take separate deductions for mortgage interest.
This commentary also will appear in the May 2012 issue of the Tax Management Real Estate Journal. 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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