Tax Court Affirms IRS Ruling Limiting Mortgage Interest Deductions for Unmarried Couples

The United States Tax Court ruled on March 5 in Sophy v. Commissioner of Internal Revenue, 138 T.C. No. 8, that the statutory cap on mortgage interest deductions applies in the same way to unmarried couples as it does to married couples, affirming a ruling by the Internal Revenue Service assessing a tax deficiency against a gay male couple who jointly own two houses.  The Court rejected the Petitioners' argument that Congress intended to impose a "marriage penalty" on married couples.

Under the Internal Revenue Code, mortgage interest is deductible from income, but not to the extent that it is attributable to an outstanding mortgage principal balance of more than $1 million.  Similarly, interest payable on a home equity line of credit that is used to finance home improvements is deductible, but not to the extent that it is attributable to an outstanding loan balance of more than $100,000.

A same-sex couple, Charles Sophy and Bruce Voss, jointly purchased houses in Rancho Mirage and Beverly Hills, California.  The Rancho Mirage house is their weekend/vacation home, and the Beverly Hills house is their principal residence.  The outstanding mortgage principal balances for the two houses exceeded $2 million in 2006 and 2007, and the outstanding principal balance on a joint home equity loan exceeded $200,000.  In filing their federal income tax returns for 2006 and 2007, they each claimed interest deductions for interest attributable to $1 million mortgage balance and $100,000 home equity loan balance, effectively asserting that each could use the full interest deduction allowance. 

The IRS, however, sent them both deficiency notices, disallowing a substantial portion of their interest deductions, asserting that the $1 million and $100,000 caps were applied per residence, not per taxpayer.  IRS pointed out that a married couple jointly purchasing a house is subject to the $1 million and $100,000 cap, even when the married couple files their income tax returns separately (in which case, each can claim deductions only for interest attributable to half the capped amounts).  And, in a prior case, IRS had taken the same position regarding unmarried different-sex couples who purchased houses jointly.

Affirming the IRS, the Tax Court focused on a literal interpretation of the Internal Revenue Code, Section 163(h)(3)(B)(ii), which it insisted imposed the cap "per residence," not "per taxpayer."  "From Congress' use of 'any indebtedness' in the definition of acquisition indebtedness," wrote the Court, "which is not qualified by language regarding an individual taxpayer, it appears that this phrase refers to the total amount of indebtedness with respect to a qualified residence and which is secured by that residence.  The focus is on the entire amount of indebtedness with respect to the residence itself.  Thus when the statute limits the aount that may be treated as acquisition indebtedness, it appears that what is being limited is the total amount of acquisition debt that may be claimed in relation to the qualified residence, rather than the amount of acquisition debt that may be claimed in relation to an individual taxpayer."  The Court found that the same analysis applied to "home equity indebtedness."

The Court found confirmation for this interpretation in the provisions stating that when married couples who jointly own a residence file separately, each is subject to a deduction cap of interest attributable to $500,000 of outstanding principal.  The Court found the argument that Congress thus intended to impose a "marriage penalty" that was not applicable to unmarried joint owners to be "unpersuasive," due to the statutes focus on the residence rather than the taxpayer in the provision describing the cap.

So, same-sex couples, married or otherwise, with large outstanding mortgages who thought they might derive a tax benefit from the refusal of the federal government to recognize their marriages or partnerships for tax purposes are mistaken in this instance, where the Tax Court's interpretation results in equal treatment!

The total amount of extra tax assessed is more than $25,000 for Sophy and more than $32,000 for Voss, perhaps enough to justify an attempt to appeal this ruling to the Article III courts.  The taxpayers were represented in this appeal to the Tax Court by attorneys Jeffrey L. Reuben and William marc Weintraub.

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