Interest Deduction Limits on the Residence: A (Wonderful) New Decision for Taxpayers!*

August 31, 2015

FIABCI-USA

This short Note examines a basic but very important issue for two (or more) taxpayers that jointly own a property that is considered the principal or secondary residence of the taxpayers. For Federal Income Tax purposes, are the Interest limitations in the Federal Tax law for interest paid to carry a loan on the primary or secondary residence limited by the residence or by the individual, unmarried taxpayers?

Factually, the Case is straight-forward. Two Taxpayers, not married to each other, owned two properties together as their principal residence and as a secondary residence. When the Taxpayers deducted the interest they paid on their loans for the properties in question, the IRS challenged the deductions as to the total amount deducted. The Government argued that the Federal tax law limited the amount of interest that could be claimed for the deduction.

This article examines this issue, as stated by the 9th Circuit decision in Voss v Commissioner, 116 AFTR 2d Para 2015-5128 (CA 9, 2015), consolidated with the Case of Sophy v Commissioner, 116 AFTER 2d Para 2015-5128 (CA 9, 2015), and referred to in this Note as the Voss decision.

Why is the Case, examined below, so important? Because this decision, which is, as the 9th Circuit stated, of first impression, arguable allows an Unlimited number of taxpayers, where they meet the requirements described below, to deduct interest on loans in a combined ownership of real estate. The IRS did not favor this result.  But, the 9th Circuit concluded that such deductions were allowable.

The following discussion examines the planning that is now available under the reasoning of this decision.

Overview of the Law Allowing Deductions for Interest on the Principal or Secondary Residences

The Federal Income Tax law is fairly clear on the basic tenet that interest paid on loans connected with the principal residence, as a generalization, is deductible. This fundamental and well established principle can be found in the tax law.  (See 26 U.S. USCA, Internal Revenue Code of 1986, as amended, Section 163, the Code being hereafter referred to simple under the “Code” Section.)

Thus, as the 9th Circuit Court noted, Code Section 163 allows for the deduction of interest paid on the loans for the property noted. Of course, there are additional limitations to claim this deduction, some of which are the focus of this case. However, first one should examine the basic rule.

Code Section 163 (a) states the basic rule on the ability to deduct interest on the Federal Income Tax return of the Taxpayer.  It states:

“There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.”

However, the Code Section further limits the deduction for what is labeled as personal interest (as contrasted with business or investment interest). The Code provides that although most personal interest is not deductible, some types of personal interest can be deducted. The authority for this rule is under Code Section 163 (h) (3). That Section states that “qualified residence interest” can be deducted, if various tests are met. Relevant to the discussion in this Note, the Court looked to the rule as to what was a residence, etc.

As to the residence, the Court stated that the interest, if deductible, must be interest in connection with loans that are on the primary residence and/or the secondary residence. This issue was not contested as the Taxpayers met this requirement. The IRS and the Taxpayers agreed on this point. (For what is the “residence,” see Code Section 163 (h) (4).  See also a full discussion of this topic in Levine, Mark Lee, and Segev, Libbi Levine, Real Estate Transactions, Tax Planning (Thomson/West, 2015), Chapter 8.)

However, the contention in the Case centered on another restraint on the deductibility of interest. Under Code Section 163 (h) (3) (B), Congress placed a limit on the amount of the loan on the subject property that can be used to calculate the interest that is deductible. The loan in connection with the qualified residences, as noted above, can be any amount. However, the interest deduction that is claimed is limited to interest on no more than 1 million dollars of loan. That is, for example, if the loan is 1.5 million, the taxpayer can only take the first 1 million of the loan and claim an interest deduction for the interest that was generated on the 1 million. The Code states:

“The aggregate amount treated as acquisition indebtedness for any period shall not exceed $1,000,000 ($500,000 in the case of a married individual filing a separate return).”

The Code also allows for an additional deduction on any qualified loan, up to $100,000, if the loan was for “home equity indebtedness.”  See Code Section 163 (h) (3). Because there was no dispute as to the nature of the loans, the qualifying debt, and so forth, these items are not examined in this Note.  Rather, the Court and the IRS were concerned with the limitations, noted above, of the 1 million and the $100,000, for these two Taxpayers.

The Controversy: Was the Limitation Based on 1.1 Million or 2.2 Million?

The Court succinctly stated the controversy:

“This is a tax dispute brought by two unmarried co-owners of real property, Bruce Voss and Charles Sophy.For the 2006 and 2007 tax years, Voss and Sophy each claimed a home mortgage interest deduction under Section 163 (h) (3) of the Internal Revenue Code, which allows taxpayers to deduct interest on up to $1 million of home acquisition debt and $100,000 of home equity debt. After an audit, the IRS determined that Voss and Sophy were jointly subject to Section 163 (h) (3)’s $1 million and $100,000 debt limits and thus disallowed a substantial portion of their claimed deductions. Voss and Sophy challenged the IRS’ assessment in Tax Court, arguing that the statute’ debt limits apply per taxpayer such that they were entitled to deduct interest on up to $1.1 million of home debt each. The Tax Court agreed with the IRS.”

The Court of Appeals held that they had to decide the issue on whether the above noted debt limits applied when two or more unmarried co-owners of a residence claim the interest deduction on amounts in excess of the $1.1 million. Said differently, the Court needed to decide if the above limits apply per residence or per taxpayer, when the taxpayers are co-owners, but not married to each other.

The Court examined the IRS position and the support for the same as voiced in the lower Court decision of this case, via the Tax Court. That is, the IRS and the Tax Court concluded that the limitations by Congress, noted above, apply per residence. This is why, argued the IRS, that if a married couple, filing separately, claims an interest deduction for the residence, the total that must be divided between the married couple is the $1.1 dollars of debt.

On the other hand, the Taxpayers argued that the statute did not limit the deduction per residence.  They argued the deduction was limited per taxpayer. And, since each of the two taxpayers in this case each had over 1.1 of qualified debt on the residences, each of them could claim the deductions on each of their $1.1 dollars of loans. (Each taxpayer had a total of more than $1.1 million in debt; thus, the Taxpayers argued they could each claim their deductions on their loans, up to the total debt of $1.1 million per taxpayer.)

The Court said that the case before them was “of first impression.” There was no prior decision before them to guide the way.  There have been cases on married couples; but, again, the Taxpayers, Voss and Sophy, were not married to each other.

The Court examined many arguments made by the IRS and the Tax Court as to the per residence position.However, the Court concluded that Congress did not, by the language of Code Section 163, place limits as to per residence. In fact, the Court stated that such limit was placed on married couples filing, claiming deductions under Code Section 163; but, Congress chose, said the Court, to not place such limits on co-owners.  Thus, the Court held:

“We conclude that Section 163 (h)’s debt limits apply per taxpayer.”

Of course, this meant a win for the Taxpayers. And, what it also means is there are planning opportunities for other taxpayers—as discussed, below.

Conclusion

The result in the case is very clear. Co-owners of real estate, if otherwise qualified, can have up to $1.1 of debt on which to claim their interest deductions in connection with interest incurred as to the primary residence and the secondary residence. How can other taxpayers, legally, employ this rule to their benefit under Code Section 163 (h) (3)?

There are many scenarios where there may be co-owners of property. And, if the given fact setting comports within the above rule by the 9th Circuit, the interest deduction on a personal basis can apply.

Assume for the moment that 5 couples own a 50 unit apartment building.  Assume that there is 50 million of debt on the property. If the debt is otherwise qualified within the earlier noted Code Section 163 limits, and each unit is of the same value (for ease of the example), then one could argue that there is debt of 1 million, proportionally, on each unit. If this is the case, can each couple claim to deduct the personal interest on the unit they occupy? That is, will this fit within the Voss Case reasoning?

If the 5 couples all each occupy one of the units as their principal residence, leasing out the other 45 units, there would be two uses of the real estate. One is for the investment use of the 45 units. The other is for the 5 personally occupied units. As to the 5 units, can each couple argue that the loan on their unit is within the limits discussed above as to Code Section 163 (h)?

It would seem to be reasonable to reach this conclusion.

Of course, one could argue that this hypothetical case is not as difficult as the Voss Case, given that each person in the apartment scenario is only occupying his or her unit; yet, in the Voss Case, both Voss and Sophy occupied the shared units. Either way, it appears that the Voss Case supports the ability of the taxpayers in the apartment case, above, to claim their personal deduction (within the limits noted above) on their unit.

Certainly this result is no different than if a building was owned in a cooperative or condominium structure, allowing each owner to claim the interest deduction as to their unit (subject to the above limits.) However, in the Voss Case, it does establish a precedent that if the owners are not married to each other, each person could have the potential $1.1 dollar limits under Code Section 163 (h). Given the activity of couples living together today, not married to each other, this decision is important as a planning tool!