Double Mortgage Interest Deduction Limit Allowed for Unmarried Taxpayers
The IRS has announced that it will not dispute the holding of a federal appeals court decision regarding the limit on mortgage interest deductions under Code Sec. 163 (Voss, CA-9, 2015-2 ustc ¶50,427). The court had found that when two or more unmarried taxpayers own a qualifying residence, certain limits on the deduction apply per taxpayer, rather than per residence. As a result, the unmarried co-owners could take a larger interest deduction than if the limit applied per residence.
Home mortgage interest is deductible if it is paid or accrues on either acquisition indebtedness or home equity indebtedness secured by a qualified residence. A taxpayer can have two qualified residences: the taxpayer’s principal residence, and one other home used by the taxpayer as a residence that is not rented to others.
Acquisition debt is debt used to acquire, construct or substantially improve a qualified residence, provided the debt is secured by the residence. The deduction for acquisition debt is limited to interest paid on the first $1 million of debt (or $500,000 for a married taxpayer filing separately). For both acquisition debt and home equity debt, married taxpayers are treated as one taxpayer, with one limit.
Home equity debt is debt secured by the qualified residence, to the extent the debt does not exceed the difference between the fair market value of the residence and the amount of acquisition debt on the residence. The deduction for home equity debt is limited to interest paid on the first $100,000 of debt.
Example: John owns a personal residence that he bought for $200,000. He took out a loan of $175,000 to buy the residence (acquisition indebtedness). The value of the home appreciates to $300,000. He later takes out a home equity loan (HEL) of $100,000 on the residence. The difference between the value of the home ($300,000) and the acquisition debt ($175,000) is $125,000. Because the amount of the HEL ($100,000) does not exceed $125,000, all of the interest paid on the HEL is deductible.
The IRS has ruled that debt incurred by a taxpayer to buy, construct or improve the home (normally, acquisition debt), can be treated as home equity debt to the extent it exceeds the $1 million limit on acquisition debt. Thus, interest paid on the debt above $1 million will be deductible. The amount of home equity debt is still subject to the $100,000 limit, but the taxpayer could claim interest paid on $1.1 million of debt.
In Voss, two individuals were domestic partners. They purchased two residences with mortgages that totaled $2.4 million. They also obtained an HEL of $300,000. Thus, the total debt was approximately $2.7 million. The unmarried taxpayers filed separate returns. Each taxpayer claimed home mortgage interest deductions on $1.1 million of debt, or a total of $2.2 million of debt.
The IRS at first determined that the $1.1 million debt limit applied per residence, not per taxpayer. The total interest deduction was limited to all interest paid on the debt, multiplied by a limitation “ratio” of $1.1 million divided by the entire mortgage amount ($2.7 million). The Tax Court agreed with limits determined by the IRS.
On appeal, the Ninth Circuit reversed. It concluded that the limits applied separately to unmarried taxpayers on a per-taxpayer basis, not a per-residence basis. Thus, unlike married taxpayers, separate limits applied to taxpayers such as the unmarried co-owners of the two properties.
The IRS has now acquiesced in the Voss decision. It will allow unmarried taxpayers to each claim interest deductions on $1.1 million of debt. It remains uncertain whether Congress will address this position, which now favors (or some say, “rewards”) unmarried individuals living together, at least above a certain income level in which mortgage debt exceeds the $1.1 million limit.