In life, exceeding limits may be good advice. In tax law, generally not so much. But sometimes taxpayers challenge the limits, and sometimes they win.
In 138 T.C. No. 8 (Sophy), a tax court case from 2012 that you can find here on the Taxing Lessons site, the taxpayers challenged the disallowance of an interest expense deduction for the mortgages on their personal residences.
Specifically, they were challenging code section 163(h)(2)(D), which allows a deduction for interest paid on $1 million of acquisition indebtedness (or refinanced acquisition indebtedness, up to the amount of the original loan’s balance), plus interest paid on $100,000 of home equity indebtedness.
The taxpayers, who were not married, paid interest on two homes they owned jointly. The homes had a combined mortgage balance of approximately $2.6 million during the years in question (2006 and 2007). The taxpayers owned the homes as joint tenants. They occupied one as a principal residence and the other as a second residence, and were jointly and severally liable for the mortgage payments. The interest was qualified mortgage debt.
On their income tax returns for 2006 and 2007, each taxpayer deducted interest paid on $1.1 million of the outstanding principal balance of the loans. Their argument: The $1.1 million limitation applies to each individual taxpayer. Since the total qualifying debt exceeded $2.2 million, each could take an interest deduction on principal loan balances up to the $1.1 million limitation.
The IRS said the allowable deduction was the interest paid on $1.1 million of qualified interest per residence(s). The taxpayers could split the deduction for interest paid on debt of up to $1.1 million, but each could not apply the limitation separately to loans on the same residence(s).
The tax court agreed with the IRS, saying the qualified mortgage interest expense deduction applied on a per-residence basis.
The taxpayers appealed to the court of appeals for the ninth circuit, which has jurisdiction over western states, including California. The appeals court decided the tax court decision was wrong.
Here is the relevant internal revenue code section.
From Internal Revenue Code Section 163(h): (h) Disallowance of deduction for personal interest
(1) In general
In the case of a taxpayer other than a corporation, no deduction shall be allowed under this chapter for personal interest paid or accrued during the taxable year.
(2) Personal interest For purposes of this subsection, the term “personal interest” means any interest allowable as a deduction under this chapter other than—
(A) interest paid or accrued on indebtedness properly allocable to a trade or business (other than the trade or business of performing services as an employee),
(B) any investment interest (within the meaning of subsection (d)),
(C) any interest which is taken into account under section 469 in computing income or loss from a passive activity of the taxpayer,
(D) any qualified residence interest (within the meaning of paragraph (3)),
(E) any interest payable under section 6601 on any unpaid portion of the tax imposed by section 2001 for the period during which an extension of time for payment of such tax is in effect under section 6163, and
(F) any interest allowable as a deduction under section 221 (relating to interest on educational loans).
(3) Qualified residence interest For purposes of this subsection—
(A) In general The term “qualified residence interest” means any interest which is paid or accrued during the taxable year on—
(i) acquisition indebtedness with respect to any qualified residence of the taxpayer, or
(ii) home equity indebtedness with respect to any qualified residence of the taxpayer.
For purposes of the preceding sentence, the determination of whether any property is a qualified residence of the taxpayer shall be made as of the time the interest is accrued.
(B) Acquisition indebtedness
(i) In general The term “acquisition indebtedness” means any indebtedness which—
(I) is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and
(II) is secured by such residence.
Such term also includes any indebtedness secured by such residence resulting from the refinancing of indebtedness meeting the requirements of the preceding sentence (or this sentence); but only to the extent the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness.
(ii) $1,000,000 limitation
The 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).
(C) Home equity indebtedness
(i) In general The term “home equity indebtedness” means any indebtedness (other than acquisition indebtedness) secured by a qualified residence to the extent the aggregate amount of such indebtedness does not exceed—
(I) the fair market value of such qualified residence, reduced by
(II) the amount of acquisition indebtedness with respect to such residence.
The 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).
ON WHAT SPECIFIC LANGUAGE IN THIS CODE SECTION DO YOU THINK THE APPEALS COURT BASED ITS CONCLUSION?
Make your choice from the code section cited above, then hover your mouse
over the link beneath “The Decision”
THE DECISIONFor a full explanation, hover your mouse over the link
DO YOU THINK THE IRS WILL FOLLOW THE APPEALS COURT DECISION?
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THE IRS DECISIONFor a full explanation, hover your mouse over the link
Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.
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The court based its conclusion largely on its interpretation of the language of the statute that expressly provides that married individuals filing separate returns are entitled to deduct interest on up to $500,000 of acquisition indebtedness and $50,000 of home equity indebtedness. By providing lower debt limits for married couples, and not for unmarried co-owners, congress singled out married couples for specific treatment, implying that an unmarried co-owner filing a separate return is entitled to deduct interest on up to $1,000,000 of acquisition indebtedness and $100,000 of home equity indebtedness.
The Internal Revenue Service will follow the Voss opinion and will apply the section 163(h)(2) and (3) limitations on a per-taxpayer basis, allowing each taxpayer to deduct mortgage interest on indebtedness of up to $1 million and $100,000, respectively, on a qualified residence.