FedTax: Mortgage Interest

California CPA: December 2009

Greater home mortgage interest deduction now allowed

By Stuart R. Josephs, CPA

The IRS has reversed its position as to whether debt, exceeding $1 million, incurred to acquire, construct or substantially improve a qualified residence constitutes “home equity debt” [Under IRC Sec. 163(h)(3)(C)].

Legislative History
The present version of Sec. 163(h)(3) was enacted by the 1987 Revenue Act. The Ways and Means Committee Report, which the Conference Committee followed, states, “… the total amount of acquisition debt that can give rise to qualified residence interest is $1 million … .”

Judicial History
In Pau v. Commissioner , TC Memo 1997-43, the Paus purchased a primary residence with a mortgage of $1,330,000. They claimed a home mortgage interest deduction, limited to interest on $1.1 million of debt.

The IRS issued a notice of deficiency disallowing this deduction. A revenue agent subsequently allowed the deduction, but limiting it to interest on $1 million of debt.
Judge Parr’s opinion states that the parties disputed the amount of debt that should be used to compute the deduction.

This opinion concludes: “Sec. 163(h) restricts home mortgage interest deductions to interest paid on $1 million of acquisition indebtedness … . Acquisition indebtedness is defined as that which is ‘incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and … is secured by such residence’ [Sec. 163(h)(3)(B)]. A taxpayer may be entitled to a greater deduction if he has incurred home equity indebtedness up to $100,000, as allowed by Sec. 163(h)(3)(C)(ii). There can be no additional deduction where taxpayers fail to show that they had home equity indebtedness. See Notice 88-74 … . Home equity indebtedness is defined as ‘any indebtedness (other than acquisition indebtedness) secured by a qualified residence’ [Sec. 163(h)(3)(C)] (emphasis added).

“Petitioners … did not demonstrate that any of their debt was not incurred in acquiring, constructing or substantially improving their residence and thus have failed to carry their burden of proof. We therefore sustain respondent’s determination as to the amount petitioners may properly deduct for home mortgage interest.”

Note : Notice 88-74 reads, in part: “Treatment of debt which is partially acquisition indebtedness and partially home equity indebtedness: Regulations will provide that a single debt may qualify as partially acquisition and partially home equity indebtedness.

“Therefore, for example, if a taxpayer incurs a debt secured by his qualified residence and uses a portion of the debt proceeds to refinance an existing acquisition indebtedness and uses the remaining portion of the debt proceeds for purposes other than the substantial improvement of the residence, the portion of the debt
used to refinance the acquisition indebtedness will qualify as acquisition indebtedness and the portion of the debt used for other purposes will generally qualify as home equity indebtedness, subject to the $100,000 limitation on home equity indebtedness.”

In Catalano v. Commissioner , TC Memo 2000-82, Judge Laro’s opinion reads, in part: “While the principal amount of the debt upon which the interest accrued was $1,341,342, … Sec. 163(h) restricts the residential mortgage interest deduction to interest paid on $1 million of acquisition indebtedness. See Pau … .”

Administrative History
Field Service Advice 200137033, which states that it should not be cited as precedent, pertinently reads: “Here, if both loans are acquisition loans, then the aggregate amount of taxpayers’ debt is in excess of the $1 million limit of Sec. 163(h)(3)(B)(ii) … . Taxpayers are only entitled to a deduction for interest paid on $1 million of acquisition debt. See Pau … ” (footnote omitted).

However, IRS Publication 936, Dec. 9, 2008, titled Home Mortgage Interest Deduction, relevantly states: “ … debt you incurred to buy, build or substantially improve your home, to the extent it is more than the home acquisition debt limit … , may qualify as home equity debt.”

Observation : IRS publications are not listed among the types of authority described in Regs. Sec. 1.6662-4(d)(iii) to determine whether substantial authority exists to avoid substantial understatement of income tax penalties.

New IRS Position
Chief Counsel Advice (CCA) 200940030, Aug. 7, 2009, which states that it may not be used or cited as precedent, deals with this situation: “Taxpayer buys a principal residence for $1.5 million, paying $200,000 in cash and borrowing the remaining $1.3 million through a loan … secured by the residence. You ask whether $100,000 of the taxpayer’s indebtedness in excess of $1 million can qualify as home equity indebtedness. If so, interest on up to $1.1 million of the debt would be deductible ($1 million of acquisition indebtedness and $100,000 of home equity indebtedness).

“Because home equity indebtedness is defined in Sec. 163(h)(3)(C) as debt other than acquisition indebtedness, the resolution of the issue depends upon the definition of ‘acquisition indebtedness.’ ”

After quoting relevant portions of Sec. 163, this CCA reasons: “We see two possible interpretations of the definition of acquisition indebtedness. Under the first interpretation, acquisition indebtedness means all indebtedness, regardless of amount, incurred to acquire, construct or substantially improve a qualified residence. That is, under this interpretation, the $1 million limitation in Sec. 163(h)(3)(B)(ii) is not an element of the definition of acquisition indebtedness, but is a separate limitation on deductibility.

“If this interpretation is correct, then a taxpayer who borrows in excess of $1 million to acquire, construct, or substantially improve a qualified residence may not treat the excess above $1 million as home equity indebtedness, because that amount, even though in excess of $1 million, remains acquisition indebtedness.

“Under the second interpretation, the $1 million limitation in Sec. 163(h)(3)(B)(ii) is an element of the definition of acquisition indebtedness, so that indebtedness that otherwise qualifies as acquisition indebtedness fails to qualify to the extent it exceeds $1 million.

“If this interpretation is correct, then a taxpayer who borrows in excess of $1 million to acquire, construct or substantially improve a qualified residence may treat the excess above $1 million as home equity indebtedness, because that amount by definition does not constitute acquisition indebtedness.

“We think the second interpretation is the better interpretation. We read the definition of ‘acquisition indebtedness’ in Sec. 163(h)(3)(B) as including both the Sec. 163(h)(3)(B)(i) and … (ii) elements. As discussed below, we think this interpretation comports with how… ‘acquisition indebtedness’ is used in other sections of the Code.”

These other sections are 56(e) and 108(h)(2).

The CCA concludes: “Indebtedness that is incurred to acquire, construct or substantially improve a residence, thus satisfying Sec. 163(h)(3)(B)(i), but that exceeds $1 million, so not satisfying Sec 163(h)(3)(B)(ii), is not acquisition indebtedness. Therefore, home equity ndebtedness, as defined in Sec. 163(h)(3)(C) includes indebtedness incurred to acquire, construct or substantially improve a qualified residence, to the extent that the indebtedness exceeds the $1 million limit on acquisition indebtedness and to the extent the other requirements of Sec 163(h)(3)(C) are satisfied.

“We recognize that the position taken in this memorandum is inconsistent with Pau … and Catalano … regarding the definition of acquisition indebtedness in Sec. 163(h)(3)(B). However, we believe that the position in this memorandum is the better interpretation of Sec.163(h)(3)(B) and (C) … .”

Comments : General Counsel Memoranda (GCM), issued after March 12, 1981, are listed among the authorities discussed in the “Observation” above. Even though CCAs are not listed, they appear similar to GCMs, but their status is presently uncertain. However, if this CCA conclusion is, or becomes, the IRS’ litigating position, additional judicial decisions on this issue
are unlikely.

Stuart R. Josephs, CPA has a San Diego-based Tax Assistance Practice that specializes in assisting practitioners in resolving their clients’ tax questions and problems. Josephs, chair of the Federal Subcommittee of CalCPA’s Committee on Taxation, can be reached at (619) 469-6999.