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Taxes
8/01/2016 @ 9:20PM 41,800 views
IRS Increases 'Marriage Penalty," Unmarried
Cohabitants To Get Twice The Mortgage Interest Deduction
There are a thousand good reasons to
never get married: in-laws, divorce attorneys, and the inevitable ravages of
age on one’s attractiveness come immediately to mind.
But there are also significant
tax hits that come with getting hitched, or as they’ve collectively
been coined, the “marriage penalty.” For example, the 28% tax bracket
kicks in at $91,150 of income if you’re single, but at only $151,900 — an amount
basic math tells you is less than double $91,150 — for married taxpayers. In
addition, single taxpayers start to lose 3% of itemized deductions when
adjusted gross income exceeds $258,250; married taxpayers, however, will lose
itemized deductions once adjusted gross income exceeds only $309,900. .
Late last week, the IRS exacerbated
the marriage penalty by offering a very large reward for
unmarried taxpayers who co-own a home: double the mortgage interest deduction
available to married taxpayer.
In AOD 2016-02, the IRS acquiesced
in the Ninth Circuit’s decision in Sophy v. Commissioner, in which the
appeals court overturned a Tax Court decision and allowed a same-sex,
unmarried, co-habiting couple to each deduct the mortgage interest on $1.1
million of acquisition and home equity debt. In reaching it’s conclusion, the
Ninth Circuit determined that the mortgage interest limitation is meant to
apply on a per-taxpayer, rather than a per-residence, basis. The AOD issued by
the IRS confirms that the Service will follow this treatment Shutterstock
Let’s take a look at what this
means:
Mortgage Interest Deductions, In
General
Section 163(h)(3) allows a deduction
for qualified residence interest on up to $1,000,000 of acquisition
indebtedness and $100,000 of home equity indebtedness. Should your mortgage
balance (or balances, since the mortgage interest deduction is permitted on up
to two homes) exceed the statutory limitations, the mortgage interest deduction
is limited to the amount applicable to only $1,100,000 worth of debt.
Now assume for a moment that you and
your non-spouse lifemate/bookie/Japanese body pillow go halfsies on your dream
house, owning the home as joint tenants. And assume the total acquisition
mortgage debt is $2,000,000 and the total home equity loan $200,000, making
total debt $2,200,000, with each of you paying interest on only your $1,100,000
share of the debt.
Are each of you entitled to a full mortgage deduction — since you each paid
interest on only $1,100,000 of debt, the maximum allowable under Section 163 —
or is your mortgage deduction limited because the total debt on the house
exceeds the $1,100,000 statutory limitation?
In 2012, the Tax Court concluded
that the answer was the latter. In Sophy v. Commissioner, this issue was
surprisingly addressed for the first time in the courts (it had previously been
addressed with a similar conclusion in CCA 200911007), with the Tax Court
holding that the $1,100,000 limitation must be applied on a per-residence
basis.
Thus, in the above example, even
though the joint tenants each paid mortgage interest on only the maximum
allowable $1,100,000 of debt, each owner’s mortgage interest deduction would be
limited under the holding in Sophy because the maximum amount of qualified
residence debt on the house — regardless of the number of owners — is limited
to $1,100,000. Assuming the joint tenants each paid $70,000 in interest, each
owner’s limitation would be determined as follows:
$70,000 * $1,100,000 (statutory
limitation)/$2,200,000 (total mortgage balance) = $35,000
Instead of each owner being entitled
to a full $70,000 interest deduction, the Tax Court concluded that the mortgage
interest deduction was limited for both because the total debt on the house
exceeded the statutory limits. The court reached this conclusion after
examining the structure of the statute and determining that the plain language
required the applicable debt limitation to be applied on a per-residence basis:
Qualified residence interest is
defined as “any interest which is paid or accrued during the taxable year 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.” Sec. 163(h)(3)(A)
The court then added, “The
definitions of the terms ‘acquisition indebtedness’ and ‘home equity
indebtedness’ establish that the indebtedness must be related to a qualified
residence, and the repeated use of the phrases “with respect to a qualified
residence” and “with respect to such residence” in the provisions discussed
above focuses on the residence rather than the taxpayer.
Ninth Circuit Reverses
In an illustration of how multiple smart people can look at the same set of
facts and reach a different conclusion, late last year the Ninth Circuit
reversed the Tax Court’s holding, deciding instead that the $1,100,000
limitation on qualified debt is determined on a per-taxpayer, rather than a
per-residence basis.
Key to the Ninth Circuit’s decision
was the statute’s treatment of married taxpayers who file separate returns for
purposes of deducting mortgage interest. Section 163(h)(3) provides that “in
the case of” a married taxpayer who files a separate return, the $1,000,000
limit on qualified residence interest and $100,000 of home equity interest are
reduced to $500,000 and $50,000 respectively. The Ninth Circuit placed great
emphasis on the use of the phrase “in the case of,” noting that it suggests an
exception to the general limitations, and that aside from that specific
exception, married taxpayers filing separately should be treated identically to
married taxpayers under Section 163.
The statute gives each separately filing
spouse a separate debt limit of $550,000 so that, together, the two spouses are
effectively entitled to a $1.1 million debt, the same amount allowed for single
taxpayers. Thus, the point of the language was to treat two married taxpayers
who file separately the same as married taxpayers or a single taxpayer, which
indicates that the limitations are to be applied on a per-taxpayer, rather than
a per-residence basis.
Lastly, the court reasoned that if
the limitation is to be applied on a per-residence basis, there would be no
need to impose a 1/2 limitation on married couples filing separately. If the
limit were indeed intended to be $1,100,000 per house, then married couples who
live together but file separately would be forced to split the limit; there would
be no need to add additional language to the statute to accomplish that result.
If the $1,100,000 limitation is to be applied on a per-taxpayer, basis,
however, the limiting language would serve a purpose, as it would prevent a
married couple who files separately from deducting interest on a total of
$2,200,000 and get twice the benefit of a married couple who files jointly.
Impact
The impact of Sophy and the
Service’s subsequent acquiescence are a bit muted in the wake of the
Supreme Court’s 2013 decision in Windsor and its 2015 ruling in Obergfell,
which together represent a seismic shift in the treatment of same-sex couples
for federal tax purposes. Going forward, same-sex couples who are legally
married under state law will no longer be forced to file as unmarried
taxpayers; rather, any couple that is married under state law, same-sex or
otherwise, will only be permitted to file married filing jointly or married
filing separately. In other words: same-sex couples — welcome to the marriage
penalty!!
Cohabitation, of course, is not
limited to same-sex couples, and so the Service’s decision to allow each
taxpayer who co-owns a house to claim an interest deduction on the full
$1,100,000 of debt — provided they are not married filing separately — should be
a welcome one for many.
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