Domestic Partners Win|Tax-Deduction Case

(CN) - Unmarried California domestic partners who jointly own homes are not subject to the interest deduction limits for married couples filing separately, and can each take the full deduction on interest of up to $1.1 million of mortgage debt, the Ninth Circuit ruled.

In a 2-1 decision on Friday, the panel reversed a decision by the U.S. Tax Court that said that Bruce Voss and Charles Sophy, who own two homes as joint tenants, were jointly subject to debt limit provisions.

Section 163 of the Internal Revenue Code allows taxpayers to deduct interest on up to $1 million of debt acquired to purchase, construct or improve a qualifying residence, and up to $100,000 of additional home equity debt, which can be used for any purpose.

The tax law cuts the limits on deductible debt in half for married individuals who file separate returns. A married taxpayer filing separately has a debt limit of $550,000.

The tax code does not specify whether residence co-owners who are not married are subject to the debt limits as applied per residence or per taxpayer.

Sophy and Voss jointly owned a primary residence in Beverly Hills and a vacation home in Rancho Mirage, on which they had mortgages and home equity debt totaling approximately $2.7 million.

Because they were separate taxpayers, Sophy and Voss determined that for the 2006 and 2007 tax years, they could each deduct interest payments on up to $1.1 million of debt.

The IRS audited the men's 2006 and 2007 returns, and ended up disallowing part of their deductions after determining that the deductible-debt limits were per residence, not per taxpayer.

Tax Court Judge Mary Cohen upheld the position of the IRS.

Finding that the language Congress used to establish the deduction limits was ambiguous, Cohen concluded that Congress' use of the term "any indebtedness" in the definition of acquisition indebtedness refers to the total amount of indebtedness with respect only to a qualified residence.

But U.S. Circuit Judges Michael Melloy and Jay Bybee disagreed with the Tax Court, concluding that the debt limits apply per taxpayer, not per residence.

The tax code is mostly silent as to how the debt limits should apply in co-owner situations, but the debt limit provisions do contain parenthetical text that speaks to married individuals filing separate returns.

The parentheticals, which call for half-sized debt limits "in the case of a married individual filing a separate return," clearly speak in per-taxpayer terms, Judge Melloy said.

"And they speak in such terms even though married individuals commonly (and perhaps usually) co-own their homes and are jointly and severally liable on any mortgage debt. Had Congress wanted to draft the parentheticals in per-residence terms, doing so would not have been particularly difficult," Melloy said.

The per-taxpayer wording of the parentheticals suggests that the wording of the main clause should also be understood in a per-taxpayer manner, the majority found.

Furthermore, the parentheticals operate in a per-taxpayer manner because they give each separately filing spouse a separate debt limit of $550,000 so that they are effectively entitled to a combined $1.1 million debt limit, the normal limit for single taxpayers, Melloy said.

Interpreted under a per-residence reading, the parentheticals "would result in disparate treatment of married couples filing separate returns," because the separately filing couple would have a $550,000 debt limit, whereas the jointly filed couple would have a $1.1 million debt limit, the judge said.

"This is surely not what the statute intended, and we don't understand the Tax Court or the IRS to say otherwise. Quite to the contrary, both acknowledge that the parentheticals' lower limits apply per spouse - which is just another way of saying per taxpayer," Melloy said.

The fact that the statute also repeatedly references to a single "taxable year" points in favor to a per-taxpayer reading, the judge said.

"Residences do not have taxable years; only taxpayers do. And, importantly, taxpayers can have different taxable years," Melloy said.

It is unclear how co-owners with different taxable years would be able to determine the aggregate amount of indebtedness under a per-residence approach, Melloy said.

"These difficult questions go away, however, when the debt limits are read to apply per taxpayer. Each co-owner simply determines the interest paid and the average mortgage debt during his or her own tax period," Melloy said.

Although applying the debt limit provisions on a per-taxpayer basis creates a marriage penalty, it is not as significant a concern as argued by the IRS, the circuit found.

"Congress presumably allows the marriage penalty because the couple also receives offsetting benefits available only to married couples filing a joint return," Melloy said.

Dissenting U.S. Circuit Judge Sandra Ikuta argued that the IRS offered an interpretation of the statute that limits unmarried taxpayers in situations such as that of Voss and Sophy to deducting the same amount as married taxpayers filing jointly.

"Under the IRS's interpretation, regardless of the number of unmarried taxpayers who have an ownership interest in a qualified residence, only interest payments no $1.1 million of the debt encumbering that qualified residence are deductible," Ikuta said.

The IRS's interpretation should be afforded a measure of respect, Ikuta said, noting that the IRS's position is "both reasonable and persuasive."

"There is no basis to infer that Congress intended to allow unmarried co-owners of a qualified residence filing separately to deduct interest on up to $2.2 million of debt, while limiting married co-owners of a qualified residence to deduct interest on only half of that," Ikuta said. (Emphasis in original.)

"A more logical inference is that the deduction was aimed at promoting home ownership for ordinary folks, not to help wealthy individuals purchase mansions that are encumbered with more than $1.1 million of debt," she said.

Subscribe to Closing Arguments

Sign up for new weekly newsletter Closing Arguments to get the latest about ongoing trials, major litigation and hot cases and rulings in courthouses around the U.S. and the world.

Email *

Submit