Couple at Beach

Last year’s decision by the U.S. Court of Appeals has created new tax planning opportunities for unmarried couples. The IRS position had been that mortgage interest limitations apply on a per-residence basis, but the Appeals Court rejected the IRS view, ruling that the debt limit provisions should be applied on a per-taxpayer basis for unmarried co-owners.

To understand how this changes things, we need to take a look at how the home mortgage deduction works.  A taxpayer can deduct interest paid on a mortgage connected with their main home or a second home, but there are limits.

Tax rules separate your home mortgage into two categories, home acquisition and home equity.

  • Home acquisition debt is the amount of the mortgage that was incurred to actually purchase or make improvements to the property.  This is limited to interest on a maximum $1million debt
  • Home equity debt is debt created when monies are borrowed that are not for the initial purchase or for improvements.  Home equity debt can be used for any purpose, and is limited to interest on a maximum of $100,000 debt.

The IRS had been applying this total $1.1million debt limit on a per-residence basis, meaning that unmarried co-owners of a qualified residence had to split that $1.1million limit between them.

Example – John and Jenny own a $3million home, with a $2.3million mortgage.  John and Jenny are unmarried, but own the property jointly and are both listed on the mortgage.  With the old view of applying mortgage interest limitations per residence instead of per individual, John and Jenny can only deduct interest on a maximum debt of $550,000 each (1/2 of the $1.1million cap).

Now the IRS has announced its agreement with the Appeals court decision, and will begin applying the mortgage interest limitation on a per-person basis rather than per-residence.  With that change, using the same facts as the above example, John and Jenny will now be able to each deduct mortgage interest on the maximum $1.1million of debt.

This can make a significant difference for unmarried co-owners with large mortgage balances.  The change is even more significant when multiplied over the life of the mortgage.

Marriage Couples Penalized?

Many have pointed out that this is another so-called “marriage penalty”.  Why should un-married co-owners be allowed to deduct double the amount that married co-owners are allowed?  The IRS treats married taxpayers as a unit. They are considered one taxpayer, whether filing jointly or separately.  Even with this new ruling, and even if a married couple files separate returns, they must still split the $1.1million mortgage debt limitation between them.

This brings up many questions and points for thought…

  • Is this a reason not to marry?  Probably not.
  • Should you put off marriage until your mortgage debt is closer to the $1.1million cap?  Maybe.
  • Will some couples decide to divorce to be able to take advantage of the higher limitation?  Though it may be tempting, probably not.

But in our society where we commonly see unmarried co-habitants, this ruling is significant.  Consult with your tax professional if you are curious how this ruling may apply in your situation.