Monday, August 20, 2012

Does Intimacy Matter in the Tax Law?

The home mortgage interest deduction has been in the news a fair amount lately, for a number of reasons.  But one that has received less attention in the media has been: what constitutes a "home" for purposes of the home mortgage interest deduction? The IRS and the Tax Court recently confronted this issue with some startling conclusions.

Slightly simplified, two unmarried taxpayers each owned their own house with a mortgage of $1 million, for which they each properly deducted the entire interest (under the law, each taxpayer is permitted to deduct interest on $1 million principal amount of mortgage, but that is capped at $500,000 per spouse for married couples filing separately).  The couple sold their separate houses and jointly bought a new house with a mortgage of $2 million, each as 50% co-owners and co-obligors.  Each taxpayer deducted half the mortgage interest.  The IRS disallowed half the interest deductions on the theory that the $1 million cap applied to the single home, not to each taxpayer separately.

The taxpayers countered with one simple fact - they were not married.  The Code clearly says that the $500,000 cap applies for a married couple filing separate returns but the cap is $1 million for everyone else. Yet that is not the end of the story - the taxpayers, although not married for tax purposes, were an intimate, same-sex couple.  The Tax Court agreed with the IRS that the taxpayers shared a single "residence" and interpreted the statute to read that the $1 million cap applied to that single residence and not to each taxpayer's share of the mortgage.

The decision raises a number of troubling issues, although there are technical and statutory arguments both in favor and against this result.  At a minimum, it is extremely difficult to determine how to draw any reasonable line under this approach.  What if the taxpayers lived in adjoining rowhouses that shared a common wall?  What if they also shared an emergency exit door?  Or they lived in neighboring apartments with shared common spaces?  What if the couple bought neighboring houses and tore down the fences so they shared a yard?

Perhaps the most troubling aspect of this case is the certainty demonstrated by the IRS and the court that the taxpayers were in fact part of a single residence.  After all, a home with a $2 million mortgage must be pretty large, presumably it would be quite easy for co-owners to pursue independent lives in a house of that size.  Maybe the IRS and the court mistakenly fell victim to the idea that this was a case about same-sex marriage?  But the logical conclusion of the case need not be limited to same-sex couples - it could apply to adult siblings sharing a house, roommates buying an apartment together to share expenses, or long-term, intimate, opposite sex couples who choose not to marry.  How are these different?  This seems like an absurd question, but implicit in it is an inquiry into the intimate nature of the relationship.

Nothing about the legal status of marriage requires spouses to pool resources, share expenses, or even like one another, but once the tax law leaves the relative safety of the bright line of marriage, the intimacy of relationships becomes relevant.  Any rule that distinguishes based on intimacy would not only permit, but would seem to require, the IRS and the courts to judge the intimacy of taxpayer relationships, or even construct what "intimate" means for these purposes.  What is intimate enough to justify tax benefits?  Would taxpayers have to kiss each other in court to prove their intimacy?  Would hiding intimate feelings become the new tax shelter?  Regardless of one's opinion about the holding in this particular case, such an approach would seem to open a door I am not sure most people would want open.  Perhaps the ultimate lesson is that we already have.

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