Archive for January 25th, 2012

Last night, I parked myself on the couch just in time for President Obama’s State of the Union Address. As a tax geek, I was excited to hear his proposals for comprehensive change to the Internal Revenue Code. I was excited to hear if he had solidified plans for the much-discussed “Buffet Rule.” I was, perhaps, most excited to hear if he would fan the flames of the perceived inequities in this country by highlighting the 13.9% effective tax rate paid by his chief opposition, leading Republican candidate Mitt Romney. This would be an address, I believed, that could change both the future of our country, and from a selfish perspective, my career.

But then I noticed Teen Wolf was on AMC, so I bagged the address and watched that instead. Hey, I’m only human.

I kid, I kid. I managed to watch the entire address — no small feat when you have a two-year old boy — and while the President left Romney’s hot-button tax rate out of his address, he did cap the night by urging Congress to require taxpayers with income exceeding $1,000,000 to pay a minimum effective rate of 30% as part of his State of the Union Address.

This is nothing new from the President, who originally floated the idea of a “Buffet Rule” that would require the nation’s wealthiest taxpayers to pay a minimum effective rate back in September, though at that time it was purely a concept with no framework for application.

This “Buffet Rule’ began to take shape on Tuesday night. While some details remain unclear, it appears this 30% rate on high-earners would be achieved not by substantially increasing the preferential rates currently in place on qualified dividends and long-term capital gains, but rather by eliminating certain deductions such as mortgage interest, tax-free health care, retirement savings and child-care benefits for those with adjusted gross income in excess of $1,000,000. The President made it clear that charitable contributions will not be impacted or further limited by the potential changes.

As we saw back in September, President Obama reiterated his commitment to taxpayers on the other end of the income spectrum, requiring that taxes not increase on those with incomes under $250,000.

Noticeably absent from the President’s address was a proposal discussed in September that taxpayers with income in excess of $250,000 but less than $1,000,000 would see a return to the top tax rates of 39.6% as of January 1, 2013, as well as a 28% cap on certain itemized deductions. I don’t know if this means the President has abandoned this proposed reform on these mid-range earners, or if it was purely omitted from the address. Time will tell.

From a corporate perspective, President Obama was adamant that comprehensive corporate tax reform is necessary to entice U.S. corporations to bring jobs back home. The President recommended a three-prong approach designed to eliminate current incentives that make it more attractive to ship jobs overseas:

  1. Eliminate tax deductions for outsourcing jobs; replace it with new tax credit to cover moving expenses for companies that close production overseas and bring jobs back to the U.S.
  2. Remove incentive to locate corporations overseas through an international minimum tax on overseas profits. If all corporations are required to pay a minimum tax on international income, other countries will not be able to entice American business through unusually low tax rates.
  3. Increase tax breaks for U.S. manufacturers by reducing rates and doubling the tax deduction for high-tech manufacturers.

All in all, there were no great surprises in the address. And let’s be honest, given the current congressional gridlock, the odds of any of these changes being enacted in the  near future are extremely slim, reducing last night’s address to one hour of spirited rhetoric.

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Yesterday was the unofficial start of “busy season” in the accounting world, which is every bit as depressing as it sounds. For the next few months we’ll be confined to our cubicles and deprived of sunlight and sound nutrition for days at a time; surviving only by adopting a singular focus on doing whatever it takes to make it until April 17th arrives to return our freedom. If busy season sounds a lot like a prison sentence, it’s because it is, only without all the free weights and shower shivvings.   

But if we’re gonna’ do it, we may as well do it right. To that end, throughout the next few months I’ll  touch on some commonly encountered tax compliance issues that are often misunderstood or misapplied. Today’s lesson: determining the deductible amount of mortgage interest when a taxpayer has total mortgage debt that exceeds the statutory limitations.

First, a primer on the limitations:

Since 1986, I.R.C. § 163(h)(3) has allowed a deduction for qualified residence interest for up to $1,000,000 of acquisition indebtedness and $100,000 of home equity indebtedness. Prior to amendment, the Code generally permitted a deduction for qualified residence interest on debt that did not exceed the basis of the residence and the cost of improvements.

Questions have surrounded the continued relevancy of temporary regulations that were issued prior to the 1986 amendments. The IRS recently answered these questions  — albeit 25 years late — in Chief Counsel Memo 201201017. The memo holds the following:

  • A taxpayer may use any reasonable method, including the exact method and simplified method provided for in the temporary regulations, to determine the amount deductible as qualified residence interest when total debt exceeds the statutory limitations.
  • Regardless of which method is used, a taxpayer may allocate any interest in excess of the limited amounts in accordance with the use of the proceeds under the interest tracing rules. Thus, if the excess proceeds are traced to use in a rental activity, the interest can be deducted on Schedule E; if they were used to purchase investments, the interest may be deductible on Sch. A as investment interest, and so on…

If those bullets make perfect sense to you, lovely. If not, read on, as a detailed explanation and illustration follows.

The Temporary Regulations

The outdated temporary regulations[i] provided two methods for determining a taxpayer’s qualified residence interest when debt exceeded the applicable limitation: the simplified method and the exact method. Citing the legislative history of I.R.C. § 163, the IRS held in CCM 201201017 that a taxpayer can also use any reasonable method to allocate debt in excess of the $1,100,000 limitation. An example of any reasonable method would be the method used in the worksheet found in Publication 936.

Simplified Method

Under the simplified method, interest on all debts is multiplied by the following fraction to determine the maximum deductible amount  :  $1,100,000/ the sum of the average balances of all secured debts.[ii]

To illustrate, assume you owned a home secured by the following debts: First mortgage: $900,000; Home equity line: $300,000; Second mortgage: $150,000.

Assume the home equity line was used for personal expenses and the second mortgage was used entirely in your rental real estate business. If the total interest expense on all three mortgages for 2011 was $80,000, using the simplified method the maximum amount of interest deductible on Schedule A as qualified residence interest would be: $80,000 * $1,100,000/$1,350,000 = $65,185.

Under the temporary regulations, if you used the simplified method you were required to treat interest on all excess debt as nondeductible personal interest. Thus, you would not be permitted to deduct any of the remaining interest in excess of the $65,185 computed above, even though the proceeds of the second mortgage were used in a rental activity. In perhaps the most important piece of CCM 20120107, however, the IRS ruled that a taxpayer using the simplified method can, in fact, apply the interest tracing rules to any interest expense in excess of the limited amount.

Exact Method

Under the exact method, the amount of qualified residence interest is determined on a debt-by-debt basis by comparing the applicable debt limit for the debt to the average balance of each debt. The applicable debt limit is an amount that is equal to the $1,000,000 limit on qualified residence debt 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, all the interest on that debt is qualified residence interest. If the average balance of the debt exceeds the limitation, the amount of qualified residence interest is determined by multiplying the interest 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 the debt.

Applying the same facts as above, the applicable debt limit for the $900,000 first mortgage would be $1,000,000, and the entire interest expense related to the debt would be deductible. The applicable debt limit for the $250,000 debt would be $100,000 ($1,000,000 – $900,000), and 10/25 of the interest expense would be deductible as qualified residence interest. The interest on an additional $100,000 of the $250,000 debt would be deductible as home equity interest. Lastly, the applicable debt limit for the second mortgage of $150,000 would be $0, as the entire $1,000,000 limitation has been used.

Under the exact method, a taxpayer is also permitted to treat interest on debt that exceeds the limitations according to the use of the debt proceeds under the interest tracing rule. Thus, though the interest on the remaining home equity line of $50,000 would not be deductible — as it was used for personal expenses — the interest on the $150,000 second mortgage would be deductible as trade or business interest under the interest tracing rules.

[i] Treas. Reg. § Section 1.163-10T

[ii] Prior to the amendment, this numerator was the adjusted purchase price of the residence.

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