Small Business Taxes & ManagementTM--Copyright 2015, A/N Group, Inc.
Sometimes even the Tax Court gets it wrong. The Tax Court is a court of limited jurisdiction. It deals only in Federal tax cases, and even then it is subject to some restrictions. Thus, you would expect the judges, who deal with Federal tax law regularly would be the court of last resort. What's even more interesting is that the issue wasn't some obscure or arcane area of tax law, it was an area that tax professionals encounter relatively frequently and dates back to 1986.
But that's not always the case. In a recent case Bruce H. Voss and Charles J. Sophy (U.S. Court of Appeals, Ninth Circuit) the Court of Appeals reversed and remanded the Tax Court's ruling in Charles J. Sophy and Bruce H. Voss 138 T.C. No. 8.
Mortgage Interest Basics
Personal interest is generally not deductible. The law does allow a deduction for mortgage interest on a "qualified residence". A qualified residence is your principal residence and 1 other residence which you select for the taxable year and which you as a residence. (A residence can include a boat or motor home that contains a kitchen and bath; special rules apply if the property is rented for part of the year; vacant land, property unsuited for a residence such as a shack on farmland, etc. doesn't qualify.)
Generally only acquisition indebtedness qualifies. That is, debt to purchase your house (refinanced debt qualifies also). Amounts borrowed for home improvements is considered acquisition debt. The debt cannot exceed the fair market value of the property at the time incurred. For example, your original mortgage is for $275,000. You have an opportunity to refinance and lower your interest rate. Closing costs will be $10,000. You roll the $10,000 in costs into the mortgage to obtain a mortgage for $285,000. Only the interest on the $275,000 qualifies. (The interest on the additional $10,000 may qualify as home equity debt.)
There's another restriction. You can only deduct the interest on the first $1 million of qualified residence debt plus the interest on an additional $100,000 home equity debt. And that limitation was precisely the issue in the case here. (The married filing separately debt limits are $500,000 acquisition debt and $50,000 home equity debt. Keep in mind that a single individual is entitled to the same limit as a married couple, $1 million and $100,000.)
Bruce Voss and Charles Sophy were unmarried co-owners of two qualified residences, a main and a vacation home. For the 2006 and 2007 tax years Voss and Sophy each claimed a home mortgage interest deduction (Sec. 163(h)(3)). That's where the interest deduction is restricted to the first $1 million of debt plus $100,000 of home equity debt. After an audit, the IRS determined that the taxpayers were jointly subject to the restriction. In other words, the $1 million/$100,000 restriction applied to the qualified residences (a main and a vacation home) and not to the taxpayers. Since the total average balance of the two mortgages was some $2.7 million, the IRS theory cut their interest deduction about in half, restricting the interest deduction to the first $1.1 million in indebtedness for the both of them rather than $1.1 for each of them or $2.2 million for the two taxpayers.
While the law is specific as to a married couple filing separately, it is silent as to the debt limit provisions when two or more unmarried co-owners of a residence claim the home mortgage interest deduction. While you might intuitively conclude that the co-owners should each be entitled to a $1 million/$100,000 limit, the Tax Court engaged in an analysis of the law and determined that the IRS was correct; the limit applies on a per-residence, not per-taxpayer basis, limiting the two co-owners to a single $1.1 million debt limit.
The taxpayers appealed. In Bruce H. Voss and Charles J. Sophy (U.S. Court of Appeals, Ninth Circuit) the Appeals Court performed an even more detailed analysis of the law and reversed and remanded the Tax Court's decision holding that the debt limit did, indeed, apply on a per-taxpayer and not a per-residence basis and the interest on the first $1 million/$100,000 could be deducted by each of the co-owners.
While it sounds like that should be the final answer on the topic, that may not be the case. First, the IRS has neither acquiesced nor not acquiesced in the decision. If the IRS indicates they will not acquiesce it means they do not agree with the decision and may fight it again.
Second, one of the three judges hearing the case dissented. That makes it somewhat less than a slam dunk.
Third, the Ninth Circuit covers the states of California, Arizona, Nevada, Oregon, Idaho, Montana, and Washington, Alaska and Hawaii. In those states the Tax Court has to follow the ruling; but not in other states.
What to do? If you're in the Ninth Circuit, you're safe to use the per-taxpayer approach, unless it's reversed again. In other areas, consult your tax advisor. Hopefully the IRS will decide to agree with the decision and end the controversy.
But the case does bring up another point. While the co-owners were not married, this could be a consideration, particularly if interest rates rise. If Fred and Sue are just friends and co-owners of a lake house with $2.2 million in debt, they can deduct all the interest. Should they get married, their interest deduction would be cut in half. Should they have a falling out after marriage and file as married, separate their deduction would each be limited to $500,000/$50,000.
Copyright 2015 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 08/27/15