The mortgage interest deduction rules limit deductible interest to the amount of interest paid on $1.1 million of qualified mortgage debt ($1.0 million of acquisition debt plus $100,000 of home equity debt). The statute is not clearly drafted about how to apply this limit and so the issue has arisen whether a same-sex couple, unmarried in the eyes of federal tax law, should be restricted to the same limit on their mortgage deduction as a married couple is. The Tax Court has just answered this question in the affirmative.
I believe the Tax Court opinion is wrong.
Over the past two years the IRS has actively audited several same-sex couples in California who own expensive homes (well, not necessarily expensive by California standards) and who therefore have mortgage liabilities in excess of $1.1 million on a single home. The recent Tax Court case, involving celebrity psychiatrist Dr. Charles Sophy, held that two unmarried taxpayers, each of whom paid interest on their own share of mortgage debts on two homes that they jointly owned, could deduct no more than a married couple could deduct. DOMA was not mentioned in the decision, but one can’t help but wonder why not since the only clear $1.1 million limitation on amount of qualified debt for calculating deductible interest mentions married taxpayers.
Oh well. It seems that DOMA sometimes applies and sometimes not.
Here’s my explanation of what happened in the Sophy case. Sophy and his partner Voss owned two homes. One had an outstanding mortgage with an original balance of $500,000 (not clear what the balance was for the tax years at issue but probably somewhat below $500,000 since they would have made principal payments over the intervening years). The second home at one point had a mortgage lien against it for approximately $2.3 million. The question in the case was how much interest they could deduct.
Section 163(h)(3) of the Internal Revenue Code allows interest deductions for qualified personal residence interest. Qualified interest is the interest paid on qualified acquisition debt and the interest paid on qualified home equity debt. The debts do not qualify unless they are secured by a qualified residence. Qualified residence in turn is defined as the principal residence of the taxpayer plus one other residence of the taxpayer.
As to qualified residences, the Code says that married individuals filing separately are treated as one taxpayer. That is, they are limited to two residences between them and one overall limit of $1.1 million of qualified indebtedness. There is no statutory rule that says how married individuals filing jointly should be treated. But the IRS has concluded (reasonably) that all married couples should be treated the same regardless of how they file. One way to look at the resulting rule is that the limit on qualified indebtedness (acquisition plus home equity) is $1.1 million per return (but married filing separately will be stuck with the same limit that applies to a joint return). Since single taxpayers file two returns, each return should be limited to $1.1 million of qualified debt and a max of two residences. The result would be that each taxpayer is entitled to $1.1 million of qualified debt and to claiming interest deductions on that total amount of debt so long as it was paid on only two qualifying residences.
There are a number of reasons I think the better construction of the statute is to read the $1.1 million limit as a limit that applies per taxpayer or per taxpayer return. Most of those reasons can be found in an article I wrote for Tax Notes. See here.
But there is another separate problem with the Tax Court opinion. The IRS concluded in 2009 that §163(h)(3)’s debt limitations should not be applied per taxpayer. CCA 200911007 (click here to read) stresses that the $1.0 million limit on acquisition debt should be applied to the aggregate amount of debt used to purchases the residence itself and not to the amount that one taxpayer borrowed to purchased his or her portion of a residence. That makes the limitation appear to apply per residence. No single home can have more than $1.1 million of aggregate qualified debt.
In the CCA the two taxpayers only owned one home. Their deductions on that home were limited to the amount of interest attributable to the qualified debt on that home. But Sophy and Voss own two homes, one with qualifying debt below $1.1 million. They should have been entitled to a deduction for all of the interest paid on that mortgage. The Tax Court, however, aggregated the debt of the two taxpayers and limited them to an interest deduction on $1.1 million of debt between them. There is nothing in the statute to justify aggregating the debt of two unmarried taxpayers. Taxpayers should appeal this decision the Court of Appeals for the Ninth Circuit.