McMahon: In Defense of CCA 200911007

Following up on Tuesday's post, IRS Limits Home Mortgage Interest Deduction for Gay/Lesbian Couples: Martin J. McMahon, Jr. (Florida) has graciously agreed to share and expand his contribution on the TaxProf Email Discussion Group, A Dissent to the Generally Expressed Views on TaxProf Regarding CCA 200911007:

CCA 200911007 (Nov. 24, 2008; released Mar. 13, 2009) addressed the amount of interest that was deductible as “qualified residence interest” under § 163(h)(3)(A) when a residence encumbered by a purchase money mortgage of more than $1 million is co-owned by two unmarried taxpayers both of whom are obligated on the mortgage and for both of whom the residence is the principal residence. Most of the participants in the TaxProf blog debate on the rectitude of CCA 200911007 described the CCA as holding that “the $1 million limitation on the deduction of mortgage interest on acquisition indebtedness under § 163(h)(3)(B) applies on a per-mortgage basis.” Most (all ?) of you that have commented have asserted that prior to the issuance of this CCA you assumed that unmarried co-owners could each deduct mortgage interest on $1 million of acquisition indebtedness, thus permitting deduction of interest on a $2 million mortgage on a home they owned in common and that the CCA is wrong.

I dissent from both the general consensus as to the conclusion and its rectitude. I read the CCA to hold that the $1 million ceiling on “acquisition indebtedness,” as defined in § 163(h)(3)(B), applies both on a residence-by-residence basis as well as on a taxpayer-by-taxpayer basis.

The CCA’s reasoning is as follows.

Under § 163(h)(3)(B)(i), acquisition indebtedness is defined, in relevant part, as indebtedness incurred in acquiring a qualified residence of the taxpayer – not as indebtedness incurred in acquiring taxpayer’s portion of a qualified residence. The entire amount of indebtedness incurred in acquiring the qualified residence constitutes “acquisition indebtedness” under § 163(h)(3)(A)(i). In this case, the amount of indebtedness incurred in acquiring [the residence] exceeds $1,000,000. However, under § 163(h)(3)(B)(ii), the amount treated as acquisition indebtedness for purposes of the qualified residence interest deduction is limited to $1,000,000 of total, “aggregate” acquisition indebtedness. This is evident from the parenthetical in § 163(h)(3)(B)(ii).

The CCA addressed only the tax consequences of one of the co-owners — the one who originally had owned the property in fee simple and was solely obligated on the mortgage and who subsequently conveyed an undivided ownership interest to a second person who also became obligated on the mortgage. The CCA concluded that the interest deductible by the taxpayer in question was to be determined by multiplying the amount of interest paid by taxpayer a fraction: $1,000,000 over the amount of mortgage. Thus, for example, if the amount of the mortgage were $1,500,000 and the taxpayer paid $75,000 of interest, the amount of the taxpayer’s interest deduction would be $50,000 ($75,000 x ($1,000,000 ÷ $1,000,000).

I believe that the reasoning and conclusion of the CCA limiting to $1 million the amount of “acquisition indebtedness” that can be taken into account collectively by all of the owners of the residence likely is correct. A careful reading of the statutory language indicates that because § 163(h)(3)(B)(ii) omits any reference to a “taxpayer,” it limits to $1 million the aggregate amount of “acquisition indebtedness” that maybe taken into account in determining the amount of “qualified residence interest” with respect all of the taxpayers that might reside in that residential unit. If it does not do so, and each taxpayer who resides in the residence is an owner, and is obligated on the “acquisition indebtedness” mortgage is entitled to deduct interest paid on up to $1 million of acquisition indebtedness, then on a joint return each of the husband and wife, who are separate and distinct taxpayers (See, e.g., Frahm v Commissioner, T.C. Memo. 2007-351), would be entitled to deduct interest on up to $1 million of “acquisition indebtedness.” But the statute clearly does not contemplate that result, as evidenced by the limitation on the deduction to the interest on $500,000 of acquisition indebtedness by married taxpayers who file separately. The parenthetical indicates, even though it does not expressly state, that a husband and wife who each own a one-half interest in the residence and are jointly and severally liable on the mortgage can deduct interest on up to only $1 million of acquisition indebtedness. An interpretation of the statute that applies the $1 million ceiling on “acquisition indebtedness,” as defined in § 163(h)(3)(B), on both a residence-by-residence basis, and on a taxpayer-by-taxpayer basis avoids this “marriage penalty” that would otherwise arise. The proffered argument by some on the TaxProf list serve that the cross reference to § 121 in § 163(h)(4) for the definition of a “principal residence” incorporates the provisions of Reg. §1.121-2(a)(2), applying the $250,000 exclusion on a per-taxpayer basis in a co-owner situation, is spurious. The cross reference does not incorporate calculational methodology, but merely the definition of principal residence. When § 163(h) was enacted in 1986, old § 1034 provided rollover for gains on the sale of a principal residence: when § 121 was enacted in 1997, § 163(h) was amended just to change the cross reference from § 1034 to § 121. The only purpose of the cross reference is to invoke rules for distinguishing a “principal residence” from a “secondary residence.”

However, even if the basic conclusion of the CCA is correct, the method of computing the amount of the deductible interest is not correct. (To be sure, it gets very complicated when secondary residences with multiple owners are introduced, and as someone who participated in the formulation of Reg. 1.163-10T, my recollection is that no one considered that issue.) Determining the deductible interest for each co-owner can be more complex. to keep it simple, if the taxpayer in question owns only a one-half interest in the residence, is jointly and severally liable on the mortgage, and paid only one half of the interest due on the mortgage, the ceiling on the deduction for that taxpayer should be the interest on the lesser of (1) one-half of the aggregate acquisition debt or (2) $1,000,000 of acquisition debt.