In a case with damaging implications for wealthy gay and unmarried couples, the Tax Court held yesterday that the $1,100,000 limitation on mortgage debt for purposes of determining deductible interest expense must be applied on a per-residence, rather than a per-taxpayer basis.
As we discussed in a previous post, I.R.C. § 163(h)(3) allows a deduction for qualified residence interest on up to $1,000,000 of acquisition indebtedness and $100,000 of home equity indebtedness. Should your mortgage balance (or balances, since the mortgage interest deduction is permitted on up to two homes) exceed the statutory limitations, your mortgage interest deduction is limited to the amount applicable to only $1,100,000 worth of debt.
Now assume for a moment that you and your unmarried girlfriend/lifemate/Japanese body pillow go halfsies on your dream house, owning the home as joint tenants. And assume the total mortgage debt — including a home equity loan of $200,000 –is $2,200,000, with each of you paying interest on only your $1,100,000 share of the debt.
Are each of you entitled to a full mortgage deduction — since you each paid interest on only $1,100,000 of debt, the maximum allowable under Section 163 — or is your mortgage deduction limited because the total debt on the house exceeds the $1,100,000 statutory limitation?
The answer, according to the Tax Court, is the latter. In Sophy v. Commissioner, this issue was surprisingly addressed for the first time in the courts (it had previously been addressed with a similar conclusion in CCA 200911007), with the Tax Court holding that the $1,100,000 limitation must be applied on a per-residence basis.
Thus, in the above example, even though the joint tenants each paid mortgage interest on only the maximum allowable $1,100,000 of debt, each owner’s mortgage interest deduction is limited because the maximum amount of qualified residence debt on the house — regardless of the number of owners — is limited to $1,100,000. Assuming the joint tenants each paid $70,000 in interest, each owner’s limitation would be determined as follows:
$70,000 * $1,100,000 (statutory limitation) = $35,000
$2,200,000 (total mortgage balance)
Instead of each owner being entitled to a full $70,000 interest deduction, the mortgage interest deduction is limited for both because the total debt on the house exceeds the statutory limits. The court reached this conclusion after examining the structure of the statute and determining that the plain language required the applicable debt limitation to be applied on a per-residence basis:
Qualified residence interest is defined as “any interest which is paid or accrued during the taxable year on acquisition indebtedness with respect to any qualified residence of the taxpayer, or home equity indebtedness with respect to any qualified residence of the taxpayer.” Sec. 163(h)(3)(A) (emphasis added).
The definitions of the terms “acquisition indebtedness” and “home equity indebtedness” establish that the indebtedness must be related to a qualified residence, and the repeated use of the phrases “with respect to a qualified residence” and “with respect to such residence” in the provisions discussed above focuses on the residence rather than the taxpayer.