The IRS Office of Chief Counsel has issued a memorandum in which it reinterprets the definition of “acquisition indebtedness” under IRC § 163(h)(3) to allow a taxpayer to deduct interest on the first $1.1 million of his or her mortgage instead of the usual $1 million limit (CCA 200940030). This interpretation is inconsistent with—and more taxpayer-friendly than—prior Tax Court holdings on the issue.
Taxpayers can generally deduct two types of debt secured by their residences: “acquisition indebtedness,” which is debt that is used to acquire, construct or substantially improve a residence, and “home equity indebtedness,” which is any other debt secured by the home. Acquisition indebtedness cannot exceed $1 million, and home equity indebtedness cannot exceed $100,000.
Prior interpretations of the term “acquisition indebtedness” have focused on the purpose of the debt and held that acquisition indebtedness means all debt, regardless of amount, used to acquire, construct or substantially improve a residence. This interpretation was used by the Tax Court in Pau, TC Memo 1997-43, and Catalano, TC Memo 2000-82.
In CCA 200940030, the IRS adopts a new and different interpretation. Under this interpretation, the $1 million limit is an element of the definition of “acquisition indebtedness.” Any amount of a mortgage in excess of $1 million is not acquisition indebtedness because, by this definition, only the first $1 million is acquisition indebtedness. It therefore follows, according to the Service’s memorandum, that a taxpayer with a mortgage larger than $1 million can treat the first $100,000 in excess of the $1 million limit as home equity indebtedness because it is other debt secured by the home. This allows the taxpayer to deduct interest on the first $1.1 million of the loan—$1 million as acquisition indebtedness and $100,000 as home equity indebtedness.
To bolster its case, the IRS examines the use of the term “acquisition indebtedness” in other parts of the Internal Revenue Code, including section 108(a)(1)(E), which provides an exclusion from income for discharge of indebtedness on a taxpayer’s principal residence, and section 56(e), which defines “qualified housing interest” for purposes of the alternative minimum tax, to conclude that Congress must have meant for the $1 million limit to be part of the definition of “acquisition indebtedness.” Notwithstanding the prior Tax Court holdings, the Chief Counsel’s Office said, “we believe that the position in this memorandum is the better interpretation of § 163(h)(3)(B) and (C).”