IRS Reverses Course on $1,100,000 Acquisition Debt vs Equity Debt Issue

The IRS Chief Counsel’s office has done an apparent “about face” regarding the treatment of acquisition debt on a home. In Chief Counsel Advice 200940030 issued on October 2, the IRS decided that a taxpayer can treat up to $100,000 in excess of the $1,000,000 limit on acquisition debt as “home equity debt” for deduction purposes.

The matter is of interest because practitioners have reported that the IRS in California had been specifically raising the issue on examination, denying interest on that extra $100,000 of acquisition debt on the basis that it failed to meet the definition of home equity indebtedness under §163(h)(3)(C).

The key question involves how you read §163(h)(3)(B) which tells us what is acquisition indebtedness, since the definition of home equity indebtedness found at §163(h)(3)(C) specifically excludes any debt treated as acquisition indebtedness.

IRC §163(h)(3)(B) has two provisions under it. The first provision, at (i), contains the rules involving the use of funds and their need to be secured by the residence. Following, at (ii), the section goes on to say:

$1,000,000 limitation. The aggregate amount treated as acquisition indebtedness for any period shall not exceed $1,000,000 ($500,000 in the case of a married individual filing a separate return).

As the CCA points out, that could either be read as a limit on the deductible amount only *OR* an inherent part of the definition of acquisition indebtedness. If the first reading is correct, then no debt that met the two test (had a qualifying use and was secured by the residence) could ever be deducted as home equity debt because it would still be acquisition debt, just a portion where the interest incurred would not be deductible.

If, instead, the $1,000,000 rule is part of the full definition of acquisition indebtedness, then any over $1,000,000 would not be such debt–and not being such debt is the key item necessary to qualify debt secured by a residence as home equity debt.

The CCA looks to resolve the question by looking at two uses of the provision in other code sections, including one added fairly recently. The author notes that §108(h)(2), dealing with qualified mortgage debt relief, is written presuming the $1,000,000 amount is part of the definition of acquisition indebtedness, and not just a limitation. As the author notes:

“…recognizing that the $1 million limitation in §163(h)(3)(B)(ii) is incorporated in the definition of the term “acquisition indebtedness,” §108(h)(2) modifies the dollar amount defining the term.”

The author goes on to note that if the $1,000,000 was not an inherent part of the definition

“If acquisition indebtedness was instead defined to include all debt used to acquire, construct, or substantially improve a qualified residence, it would not be necessary for §108(h)(2) to modify the definition of acquisition indebtedness. Instead, it would suffice simply to state that acquisition indebtedness, limited to $2 million, is eligible for exclusion. “

The author goes on next to §56(e) for the alternative minimum tax, and raises a theory that I suspect might account for the “about face” on the matter given the impact of the alternative minimum tax in California, a state where this issue appeared to keep coming up. The author notes that §56(e) defines “qualified housing interest”, which is fully deductible for alternative minimum tax purposes per §56(b), as qualified residence interest under §163(h)(3) (meaning both acquisition and home equity regular income tax interest) and is incurred in acquiring, constructing, or substantially improving the property. If the $1,000,000 is not part of the definition of acquisition indebtedness, the there would no limit on deductible acquisition debt under §56(b) for purposes of the alternative minimum tax.

Since that, in the view of the author, is contrary to the intent of Congress, the proper reading is that the $1,000,000 limit is part of the definition of acquisition indebtedness, and therefore the interest on another $100,000 of a qualifying debt can properly be treated as home equity debt for deduction purposes.

The CCA goes on to note that the position is contrary the results in Pau v. Commissioner, TC Memo 1997-43 and Catalano v. Commissioner, TC Memo 2000-82.

This memo may raise as many questions as it answers. However, if you have client with this situation, especially one where the agent is challenging the deduction, it could prove useful. And, perhaps, if you have a client who was subject to the alternative minimum tax with a large mortgage outstanding, you might want to take a look at the analysis posed in the memo presuming it should be read as the court did in Pau and Catalano.