The Government has filed its brief in the taxpayers’ appeal to the Ninth Circuit of the Tax Court’s decision that the mortgage interest deduction applies on a per residence rather than per taxpayer basis. See our previous coverage here. Section 163(h)(3) limits deductible mortgage interest to “acquisition indebtedness” of $1,000,000 and “home equity indebtedness” of $100,000. With their Beverly Hills home and Rancho Mirage secondary residence, domestic partners Bruce Voss and Charles Sophy had considerably more indebtedness, and argued that, together, they should be able to deduct interest paid on up to $2.2 million of acquisition and home equity indebtedness because the limitations should be applied on a per taxpayer rather than per residence basis. In its opposition brief, the Government argues that the statutory text supports a per residence limitation. The statute refers to acquisition or home equity indebtedness “with respect to any qualified residence of the taxpayer.” According to the Government, “the word ‘indebtedness’ is used in direct relation to the ‘residence,’ and the word ‘taxpayer’ is used only in connection with the ‘residence,’ not with the ‘indebtedness.’” The Government also finds support for its position in the Code’s definition of “acquisition indebtedness” as indebtedness incurred in acquiring a residence, not as indebtedness secured in acquiring a taxpayer’s portion of a residence. Turning to policy arguments, the Government observes that the taxpayers’ interpretation would create an unintended marriage penalty. Married taxpayers filing separately are limited to acquisition and home equity indebtedness of one-half the otherwise allowable amount, or $500,000 and $50,000 respectively.
In their reply brief, the taxpayers argue that the general rule of section 163(a) (“There shall be allowed as a deduction all interest paid within the taxable year on indebtedness.”) must be read as referring to the taxpayer’s indebtedness. This “clearly implied” meaning, they argue, should inform the interpretation of the mortgage interest deduction provisions. The taxpayers also seek support for their interpretation in references in the legislative history to the indebtedness on the qualified residence as being “the taxpayer’s debt.” With respect to the Government’s marriage penalty argument, the taxpayers note that the Code often treats married couples as a single taxpayer, and married couples enjoy many benefits from that treatment, benefits that are not enjoyed by domestic partners. The reply brief concludes with the following: “Once Congress made the decision to treat spouses as a single taxpayer, the resulting benefits and burdens must be respected equally. In this case, Taxpayers should not be assigned the burden (or penalty) that results from the Tax Court’s convoluted reading of section 163(h)(3) which treats Taxpayers as a married couple, when they receive none of the marriage benefits.”
Briefing Underway in Ninth Circuit on Question of Mortgage Interest Deduction for Non-married Couples
Last spring, the Tax Court held in Sophy v. Commissioner, that the limitations on indebtedness for the mortgage interest deduction are applied on a per residence rather than per taxpayer basis. The taxpayers appealed to the Ninth Circuit (Nos. 12-73257 and 12-73261), and filed their opening brief on January 30. The government’s response is due in March.
Under I.R.C. § 163(h)(3), taxpayers are allowed to deduct “qualified residence interest,” which includes interest paid or accrued on acquisition indebtedness with respect to any qualified residence of the taxpayer, or home equity indebtedness with respect to any qualified residence of the taxpayer. For purposes of the deduction, acquisition indebtedness is capped at $1 million and home equity indebtedness is capped at $100,000, for a total indebtedness limit of $1.1 million on up to two residences. The taxpayers, an unmarried couple registered as domestic partners with the State of California, had approximately $2.7 million of indebtedness associated with their primary residence in Beverly Hills and secondary residence in Rancho Mirage, California. They argued that, together, they should be able to deduct interest paid on up to $2.2 million of indebtedness, or $1.1 million each. The Tax Court rejected this position. Parsing the language of the statute, the Tax Court noted repeated references to “residence” in the provisions on the indebtedness limitations and concluded that the limitations are “residence focused rather than taxpayer focused.” The Tax Court also found support for treating the $1.1 million limitation as a per residence rather than per taxpayer limitation in the subsection of § 163(h) that provides that married taxpayers who file separate returns are limited to half of the otherwise allowable amount of indebtedness, and in the general rule that married couples filing jointly are subject to the $1.1 million limitation.
On appeal, the taxpayers argue that § 163(h) should be construed consistently with I.R.C. § 121, which limits the exclusion of gain from the sale of a taxpayer’s “principal residence” to $250,000. Under the regulations, the limitation is applied on a per taxpayer, not per residence basis. Section 163(h) defines “principal residence” with reference to § 121. The taxpayers also argue there is no reason to treat non-married couples the same as married couples for purposes of § 163(h) because differential treatment “is consistent with various provisions of the Code where there is a different result for similarly situated taxpayers based on filing status.”