Qualified Residence Interest (QRI), which includes interest on acquisition indebtedness and home equity indebtedness, is excepted, under Section 163(h)(3), from the disallowance of the deduction for personal interest. Both types of indebtedness must be secured by a qualified residence, but, unlike acquisition indebtedness, home equity indebtedness may be used for purposes other than acquiring, construction, or improving the residence. Debt qualifying as home equity indebtedness, however, is limited to $100,000. In addition, since QRI is included in itemized deductions which may be limited in the case of high income taxpayers, there is the possibility that only 20 percent of QRI may be deductible. Thus, the ability to elect out of home equity treatment has become increasingly important.
Electing out of QRI:
A taxpayer may elect to treat any debt that is secured by a qualified residence as not secured, as shown in the following example.
Apparently, Congress intended that such interest would not be characterized as business interest without the election. The Conference Report accompanying TRA ‘86 noted, for example, that interest on a refinancing secured by the taxpayer's residence "is treated as qualified residence interest, regardless of the purpose for which the borrowed funds are used by the taxpayer." [H.R. Rep. No. 841, 99th Cong., 2d Sess. II-155 (1986)]
Temporary Regulation 1.163-8T(m)(3) provides: "... qualified residence interest (as defined in IRC Sec 163(h)(3) is not taken into account in determining the income or loss ... for purposes of (passive activities) ... or in determining the amount of investment interest ...".
Mixed Use of Proceeds:
This example raises the issues of not only whether an election can be made for a part of the debt but also, if such fractional election is not allowed, whether the election will be null and void or effective for the entire debt.
Taxpayer Elections:
Congress and the courts have been adamant in forcing clarity of the taxpayer's position with respect to elections. Justice Oliver Wendell Holmes was brief and to the point when he wrote, in another context but appropriate to elections: "Men must turn square corners when they deal with the Government. If it attaches even purely formal conditions ... those conditions must be complied with. ...[T]he words are there in the statute and the regulations, and ... they mark the conditions of the claimant's right." [ Rock Island, Ark., & La., R.R. Co., 254 U.S. 141 (1920)]
Specifically on elections, the U.S. Supreme Court stated: "[T]hat opportunity was afforded as a matter of legislative grace; the election had to be made in the manner and in the time prescribed by Congress. ... If [the taxpayer's] view were adopted, taxpayers with the benefit of hindsight could shift from one [method] to another in light of developments subsequent to their original choice." [Riley Inv. Co. V. Comm'r, 311 U.S. 55 (1940)]
Perhaps a relatively recent Tax Court memorandum case best summarized the concept, stating: "The courts should not impute to a [taxpayer] a pivotal status for Federal income tax purposes that has not been firmly and clearly elected." [Smith v. Comm'r, T.C. Memo 1988-18] See also Thurman, (T.C. Memo 1998-233) for an excellent discussion re "substantial compliance" vs "conflicting actions" regarding elections in the text surrounding endnotes 10 & 11.
Fragmentation:
A private letter ruling issued in 1993 (PLR 9335043) is premised upon the condition that the temporary regulation (which had been written to apply to the Code as it existed for the year 1987) applies after 1987. More noteworthy is that it sheds some light on the Service's position on a "fragmented" election, stating: "... if (the taxpayer) makes the election ... NO PART ... will be qualified residence interest ..." (emphasis added). To the best of this writer's knowledge, there has been no litigation on this issue.
Note also that IRS Publication 936, since at least 1992, has provided for this election as a "choice" to treat the debt as not secured - "... you can choose to treat ANY DEBT secured by your qualified home as not secured by the home..." (emphasis added).
Consequences of a Fragmented Election:
In Plumb v Comm'r, 97 T.C. 632 (1991) the Tax Court held that fragmenting the NOL election rendered the election invalid. Compare this result to Branum, 17 F.3d 805, CA-5 (1994) in which the court held that the election had been affirmatively made, even though a state of confusion existed at the time of the election as to whether it could be fragmented. However, also see Miller, Bradley C, 99 F.3d 1042 (CA-11, 1996) which held that use of the singular "loss" (instead of "losses") in the election created sufficient ambiguity to negate the election to forego the carryback.
The Federal Tax Division, American Institute of CPAs in Comments on Temporary Regulations dated March 16, 1988, requested clarification of how the election is to be made. If a taxpayer can interpret the Publication 936 commentary to mean that by characterizing the interest the taxpayer has made the election, the question of whether an "invalid" election results if the resulting interest deduction is fragmented is not as clearly defined as in the Plumb case (above).
Conclusion:
Taxpayers obviously will have more certainty as to the consequences of such transactions if they take out separate loans where proceeds are to be used for mixed purposes. The taxpayer can make the election as to only the business-purpose loan.
Temporary Regulations Section 1.163-10T(o)(5) provides that a taxpayer can elect to treat home equity debt as not secured by the residence, thus freeing the debt from the dollar limitation and making it available for the general interest deduction, if applicable. If, however, the election is in effect and the debt proceeds are used for personal purposes, the interest deduction is lost since it no longer meets the QRI exception. The election may be revoked only with the consent of the Internal Revenue Service.
The regulations do not address whether a taxpayer can make the election with regard to only a portion of a debt. One commentator noted that if, for example, a taxpayer used a portion of the proceeds of a second mortgage for business purposes, then if the temporary regulation "encompasses an election to treat a specified portion of a debt as unsecured, [the taxpayer] can use the election to shift the interest deduction attributable to the home equity debt from Schedule A to Schedule C". [Jones, "Planning With the Interest Tracing Rules--Doubts Remain," 70 J. Tax'n 216, 219 (1989)]
Tax elections are generally provided for in the Internal Revenue Code, with guidance found in the regulations. The election to treat home equity debt as not secured by a residence, however, is itself granted in the regulations. Congress "clarified" that the IRS "may prescribe the manner of making of any election by any reasonable means". [Comm Rpt accompanying 1998 Act amendment to IRC Sec 7805(d)]
Temporary Regulations Section 1.163-10T(o)(5) permits an election for "any debt", and, in the example therein, the election was applied to one of three separate debts. It may be difficult to overcome a presumption that the regulation precludes fragmentation and that, in so limiting the election, the Service did not abuse its authority.
A similar dilemma regarding whether fragmentation would be allowed was faced in TRA ‘86, where a separate net operating loss (NOL) calculation under the alternative minimum tax (AMT) forced taxpayers to consider electing to forgo the AMT NOL carryback period on the condition that the taxpayer was not simultaneously required to forgo the regular NOL carryback. The Staff of the Joint Committee on Taxation recognized the need for clarification, and concluded that the election could not be fragmented.
It appears clear that the tracing rules would apply if an election was found effective as to the entire debt. Thus, in example 2 (above), tracing could result in 80 percent of the interest being nondeductible personal interest as the price for attempting to treat 20 percent as business use. In addition, the 20 percent accuracy-related penalty could apply.
This material should be viewed only as a general summary of the tax law as of its indicated date, and not as a substitute for tax consultation in a particular case. Your questions and comments would be appreciated.
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