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Archive for October 5th, 2012

The following question came into Double Taxation HQ last night:

If I have a client with a 1,200,000 mortgage that was taken out to acquire a home and no home equity loan, am I limited to deducting interest on only $1,000,000 of mortgage, since it is all acquisition debt, or can I treat an additional $100,000 of the mortgage as home equity debt even though it’s “really” acquisition debt?

It’s an interesting question, because Section 163 provides a deduction for interest on $1,100,000 of mortgage interestfor “qualified residence interest,” which is further defined as “interest paid on acquisition indebtedness or home equity indebtedness…”

Section 163(h)(3)(B)(i) further provides that acquisition indebtedness is any indebtedness that is incurred in acquiring, constructing, or substantially improving a qualified residence and is secured by the residence. However, Section163(h)(3)(B)(ii) limits the amount of indebtedness treated as acquisition indebtedness to $1,000,000 ($500,000 for a married individual filing separately). Accordingly, any indebtedness described in Section 163(h)(3)(B)(i) in excess of $1,000,000 is, by definition, not acquisition indebtedness.

Under Section 163(h)(3)(C)(i) home equity indebtedness is any indebtedness secured by a qualified residence other than acquisition indebtedness, to the extent the fair market value of the qualified residence exceeds the amount of acquisition indebtedness on the residence. However, § 163(h)(3)(C)(ii) limits the amount of indebtedness treated as home equity indebtedness to $100,000 ($50,000 for a married individual filing separately).

In the question above, it would be reasonable to conclude that interest on only $1,000,000 of the $1,200,000 mortgage would be deductible, because there is only acquisition indebtedness; there is no home equity debt. In two court cases — Pau v. Commissioner, T.C. Memo 1997-43 and Catalano v. Commissioner, T.C. Memo 2000-82 — the Tax Court embraced this exact theory, denying a taxpayer an interest deduction on their mortgage balance in excess of $1,000,000 when there was ONLY acquisition debt.

In Revenue Ruling 2010-25, however, the IRS announced that it would not follow the Tax Court’s decisions in Pau and Catalano. Instead, in the fact pattern above, the IRS will allow the taxpayer to treat the first $1,000,000 of mortgage debt as acquisition debt, and a second $100,000 piece of the same debt as home equity debt, even though it is simply an additional part of the original debt. The theory being that by definition, acquisition debt cannot exceed $1,000,000 for purposes of Section 163(h)(3)(B)(ii).

This means that the first $100,000 debt in excess of that amount satisfies all the requirements of home mortgage debt: it is secured by the residence, it is not acquisition debt, and it does not exceed the FMV of the home.

Thus, even though the taxpayer has only one mortgage with a balance of $1,200,000 that was used to acquire the property, only $1,000,000 is treated as mortgage debt, and the next $100,000 is treated as home equity debt. This gives the taxpayer an interest deduction on an additional $100,000 of debt than was given to the taxpayers in Pau and Catalano.

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After we discussed some of the questions surrounding Mitt Romney’s mid-week proposal to achieve the necessary base broadening necessary to pay for his proposed 20% across-the-board tax rate cuts by implementing a $17,000 cap on a taxpayer’s deductions, Bloomberg reached out to me to crunch some numbers in order to determine the impact such a cap would have on a hypothetical family of four.

The Bloomberg article is here, but the full computations are below:

Assumptions:

  • Family income is all ordinary income from wages: $150,000
  • Family has an outstanding 30 year mortgage at 5 percent with a beginning balance in 2012 of $300,000. This gives rise to deductible mortgage interest for 2012 of $13,666.
  • Family lives in Ohio, where it pays real estate taxes on its home of $5,000 annually.
  • Family contributes $4,000 to charity.
  • Family withholds $6,000 in deductible Ohio state tax from wages
  • Family’s taxable income would fall in what is currently the 25% bracket, but would be the 20% bracket under Romney’s proposed 20% across-the-board reductions. The rates would be 8% on the first $17,400 of income, 12% on the next $53,300 of income, and 20% after that.
  • Under proposed Obama rates, (Scenario 2), the rates would be 10%/15%/25%.

Analysis:

Scenario 1: Using Romney’s Projected 2012 Tax Rates; No Cap on Deductions

AGI: $150,000

Itemized deductions: $28,666

Taxable Income: $106,535

Exemptions:   $15,200

Taxable Income: $106,134

Federal Income Tax: $14,874

Scenario 2: Using  Obama’s Projected 2012 Tax Rates; No Cap on Deductions

AGI: $150,000

Itemized deductions: $28,666

Taxable Income: $106,535

Exemptions:   $15,200

Taxable Income: $106,134

Federal Income Tax: $18,783

Scenario 3: Using Romney’s Projected 2012 Tax Rates; $17,000 Cap on Itemized Deductions Only; Personal Exemptions Allowed in Full.

AGI: $150,000

Itemized deductions: $17,000

Taxable Income: $133,000

Exemptions:   $15,200

Taxable Income: $117,800

Federal Income Tax: $17,208

Scenario 4: Using Romney’s Projected 2012 Tax Rates; $17,000 Cap Applies to BOTH Itemized deductions AND Personal Exemptions

AGI: $150,000

Itemized deductions: $17,000

Taxable Income: $133,000

Exemptions:   $0

Taxable Income: $133,000

Federal Income Tax: $20,248

 Summary

As you will see, because of the effect of Romney’s reduction in the tax rates by 20%, even when he caps a taxpayer’s itemized deductions — but only his itemized deductions  — (Scenario 3: Federal Tax of $17,208), our hypothetical family of 4 will stay pay-less under Romney’s plan than it would under that of Obama (Scenario 2: Federal Tax of $18,783).

When comparing Romney’s plan without a cap (which would be nearly impossible if he plans to keep the rate cuts revenue neutral) to that of his plan with a $17,000 cap on itemized deductions, our family of four saw their federal tax increase by $2,333.

Now, if we assume Romney will cap the benefit of BOTH itemized deductions and personal exemptions at $17,000, as his campaign seems to have indicated this week — our family of four would pay more (Scenario 4: Federal Tax of $20,248) than it would under the Obama plan (Scenario 2: Federal Tax of $18,783).   This would also increase our family of four’s taxes by $5,374 when compared to a Romney baseline with no cap, and $1,465 when compared to a Romney baseline where the cap applies only to itemized deductions.

The devil, of course, is in the details, and at this point, they are sorely lacking. On Wednesday night, Romney again referenced the possibility of using a cap to pay for his tax cuts, but this time quoted “$25,000 or $50,000” as a potential solution, which would obviously change the results dramatically.

Lastly, and perhaps most importantly, the Romney campaign clarified this week that it would not seek to change the current tax-free nature of employer paid health insurance coverage, a change that would have greatly increased the tax burden of the middle class.

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