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IRS Fixes A Tax Court Slip-Up

Tax laws are seldom models of clarity. Sometimes they are more garbled than a software manual that has been computer-translated from Malay to English.

Occasionally, however, the law is pretty clear, but the interpretation gets twisted.

Every professional tax adviser runs across this situation. A client may find an article on the Internet that says he can avoid taxes by putting all his assets in a trust, establishing a new church headed by himself, and donating the trust assets to his new church. We have to explain that such strategies may result in prison time or psychiatric treatment, but will not reduce taxes.

Or the Internal Revenue Service may want a particular result so badly that it reads the law in a way nobody else could. Not long ago, an agent who was examining my tax return — and finding very little to question — asserted that I must have received undocumented income from myself. If you think this is impossible, you are correct. The agent backed down when a supervisor told him that this was not a position he ought to pursue. If the IRS does not back down from a silly position, a taxpayer can take matters to the Service’s generally fair and competent appeals office, or to the U.S. Tax Court.

Occasionally, however, it is the Tax Court itself that gets tangled in a twisted web of tax logic. So it caught my eye recently when my colleague, Eric Meermann, forwarded an IRS pronouncement stating that the Service will not follow a Tax Court ruling that improperly limits homeowners’ deductions for mortgage interest.

Here is the situation: Back in 1986, Congress decided to limit the amount of mortgage interest homeowners could deduct. It allowed deductions for interest on the first $1 million of mortgage debt used to acquire, construct or improve a primary residence or a vacation home. It also permitted deductions for up to $100,000 of home equity debt, which is debt secured by a lien against the home. The home equity debt can be used for any purpose, not just to acquire or improve a residence.

As I wrote here recently, this is why so many Americans came to have second mortgages. Home equity allowed individuals to borrow money for any purpose and still deduct the interest, as long as the borrowing was secured by a home.

Practitioners realized that by putting the two rules together, they could actually deduct the interest on up to $1.1 million of qualifying mortgage principal. The first $1 million would be the qualified acquisition indebtedness (to use the tax code’s technical term), while the last $100,000 would be deductible as home equity debt. There was nothing in the law that said home equity debt could not be used to acquire the home in the first place.

Somehow, the Tax Court managed to get lost on this fairly clear path. In a 1997 case that centered on a different issue (whether a couple should be penalized for leaving $1 million of income off their tax return), the court decided that only the interest on the first $1 million of debt could be deducted. Because the additional $100,000 was used to acquire the residence, rather than, say, to take a vacation cruise, the Tax Court denied the deduction.

This is the kind of thing a judge might do if he is so irritated (perhaps because a taxpayer omitted $1 million of income) that he is not thinking clearly about issues that ought to be decided in the taxpayer’s favor.

As far as I know, the 1997 decision was generally ignored, except for a second Tax Court case in 2000, which likewise centered on other issues. But the Tax Court precedent remained out there, where it could be raised again in the future by the IRS, or even be used to justify penalties against taxpayers and practitioners for taking the position that the law allows deductions for interest on up to $1.1 million of mortgage debt.

So I give the IRS credit for stepping up to the plate. In Revenue Ruling 2010-25, the Service announced that it will not follow the Tax Court’s logic on mortgage debt. As far as the IRS is concerned, taxpayers can go ahead and deduct the interest on up to $1.1 million of qualifying debt. In effect, the Service is conceding the issue before it is raised.

This is not really a victory for taxpayers or a concession by the IRS. It is an affirmation that a tax administrator’s job is to enforce a fair and reasonable reading of the tax laws. It is not a game of “gotcha” for the Service, or “hide the cheese” for the taxpayer. At least, it is not supposed to be.

There are going to be plenty of times when we practitioners interpret the law differently from the Service. The Tax Court usually takes on the role of referee in these battles. Typically, victory goes to the side whose reading of the law is the most reasonable and least aggressive.

This time, however, it was the Tax Court that got it wrong, and the IRS that made things right.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, The High Achiever’s Guide To Wealth. His contributions include Chapter 1, “Anyone Can Achieve Wealth,” and Chapter 19, “Assisting Aging Parents.” Larry was also among the authors of the firm’s previous book Looking Ahead: Life, Family, Wealth and Business After 55.

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