Acquisition Indebtedness and Home Equity Indebtedness (Voss vs. Commissioner in the Tax Court)

In Part I, we described the requirements for a mortgage interest deduction under IRC 163(h)(3).  We noted that only the first $1.1 million of indebtedness is deductible – $1,000,000 in acquisition indebtedness ($500,000 for each married person filing separately) and $100,000 in home equity indebtedness ($50,000 for each married person filing separately).  In this post we will discuss a 2012 Tax Court ruling that supported an IRS decision to apply these mortgage interest limitations on a per-residence basis and which had negative implications for unmarried, cohabitating couples who purchase expensive properties together.  In Part III, we will explain the Ninth Circuit’s reasoning for reversing that decision.

Voss vs. Commissioner

Bruce Voss and Charles Sophy, domestic partners registered with the State of California, purchased two homes as joint tenants – a primary residence in Beverly Hills and a second home in Rancho Mirage.  They bought their homes in 2000 and 2002, with mortgages and a line of credit totaling $2.7 million, on which they were jointly and severally liable and which was secured by the properties.  On their separate tax returns, Voss and Sophy deducted the respective amount of interest each paid on the mortgages and line of credit.

Following an audit for the 2006 and 2007 tax years, the IRS applied a limitation ratio to the total amount of mortgage interest paid by each of the partners and disallowed a total of $117,106 of Voss’s claimed deductions and $79,701 of Sophy’s claimed deductions.  Voss and Sophy took the IRS to Tax Court, which held in the IRS’ favor.

The issue here was whether the IRC 163(h)(3)(B)(i) and (C)(i) debt limitations apply per taxpayer or per residence.  If they apply per taxpayer, then Voss and Sophy would each be entitled to a $1.1 million limit on their mortgage debt, and together would be able to deduct interest payments on up to $2.2 million of their acquisition and home equity indebtedness.  If the limitations apply per residence (the IRS position which was favored by the Tax Court), then the $1.1 million debt limitation would have to be divided between the owners.

The statute does not state how the debt limits apply to unmarried co-owners.

The Tax Court stated that the term “any indebtedness” in both IRC 163(h)(3)(B)(i) and (C)(i) focuses on the residence and not the taxpayer, and that all references to married persons in that section are consistent with a per-residence and not a per-taxpayer interpretation of the mortgage interest deduction.  Those sections, the Court said, state that married couples filing jointly may deduct interest on no more than $1 million of acquisition indebtedness and $100,000 of home equity indebtedness, and if they are filing separately, the parentheticals contained in the statute clarify that a limit of $500,000 of acquisition indebtedness and $50,000 of home equity indebtedness would apply to each.

The Ninth Circuit disagreed. Its reasoning will be covered in Part III.

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