While it is common knowledge that the Internal Revenue Service (IRS) allows a deduction for mortgage interest, many are unaware of the limits on the amount of the tax deduction. A taxpayer may deduct interest on up to only $1 million of acquisition indebtedness, plus interest on up to $100,000 of home equity debt. For married taxpayers filing separately, the limit is $500,000 and $50,000, respectively. Acquisition indebtedness is debt incurred to acquire, construct or substantially improve a taxpayer's main or second home. While the debt limitations are well-defined for married filers, the debt limitations were not always clear for unmarried taxpayers owning property together. However, a recent IRS announcement has settled the uncertainty.
The IRS had long maintained that the $1.1 million aggregate limit must be split between co-owners. Last year, the Ninth Circuit Court of Appeals ruled otherwise in Voss v. Commissioner. In Voss, two unmarried taxpayers owned two homes together. The homes were subject to approximately $2.4 million in acquisition debt and an additional $300,000 in home equity debt.
The taxpayers in Voss each deducted interest attributable to a total balance of $1.1 million, or a $2.2 million deduction in the aggregate. The IRS contested these deductions and asserted that the $1.1 million limitation must be split between the two co-owners, effectively limiting the taxpayers' deduction for mortgage interest to the interest on the first $550,000 of mortgage and home equity loan balances, akin to the limitations on married filing separately individuals. At trial, the Tax Court agreed with the IRS's position.
On appeal, the Ninth Circuit reversed the Tax Court's finding, holding that the $1.1 million limitation applies on a "per taxpayer" basis. The court looked to the language of the statute and interpreted the existence of the separate limitation for married filing separately individuals as an exception to the general limitation of $1.1 million for unmarried and married filing jointly taxpayers. The court reasoned that as this married filing separately exception is applied on a per taxpayer basis to each of the separate returns, so too should the general limitation be applied per taxpayer. Therefore, the court ruled that each of the unmarried taxpayers was entitled to deduct mortgage interest based on their attributable share of mortgage and home equity loan balances, up to $1.1 million each.
Despite the favorable ruling for unmarried taxpayers, uncertainty lingered until the IRS's recent announcement that it will not appeal the decision and will apply the court's holding to similar situations going forward. By announcing its acquiescence to the Ninth Circuit ruling, the IRS has confirmed that it will calculate the mortgage interest limitation on a per taxpayer basis nationwide.
Since the mortgage interest deduction is applicable to the taxpayer's primary residence combined with one additional residence, the $1.1 million limitation may arise more often than one might initially contemplate. As real estate markets continue to recover in New York, California and places in between, the average cost of a primary residence is steadily increasing, while the limitation is not indexed for inflation. Factor in the burgeoning vacation home industry, and one can see more scenarios where this limitation could apply. While this ruling was directly applicable to two unmarried individuals, jointly held property between two married couples or between a married couple and an unmarried individual may also benefit from an increased deduction.
If you own property jointly with an individual other than your spouse, and are subject to mortgages in excess of $1.1 million, you may stand to benefit from additional mortgage interest deductions. Taxpayers in this situation may also wish to consider filing a claim for refund if their previously filed returns did not utilize the full $1.1 million mortgage interest limitation.
If you would like more information about this topic or your own unique situation, please contact John I. Frederick, J.D., LL.M., or the Tax Accounting Group practitioner with whom you are regularly in contact. For information about other pertinent tax topics, please visit our publications page located here.
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