Contents

Draft letter with Regulatory Proposals
Proposal for Addition to Reg. § 1.163-8T(m)(1)
Proposal for Addition to Reg. § 1.163-8T(m)(2) and Reg. § 1.163-10T(b)
Proposal for Changes to Reg. § 1.163-10T(p)(3)(iii)
Proposal for Change to Reg. § 1.163-10T(r)
Proposal for Additions to Regulations under I.R.C. §§121 and 1034

 

 

Draft letter for the Senator to send with the regulatory proposals

 

January XX, 1997

The Honorable Donald C. Lubick
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Room 3120
Washington, D.C. 20220

 

The Honorable Margaret Richardson
Commissioner
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20224

Re: Tax Proposals Concerning Residences

 

Dear Assistant Secretary Lubick and Commissioner Richardson:

 

It has come to my attention that there are several areas of the tax regulations that are unclear or troublesome for homeowners. I am enclosing several residence related domestic relations and interest expense regulatory proposals that have been submitted to you previously by the American Institute of Certified Public Accountants (AICPA) that I believe deserve additional attention. I am hearing many problems from my constituents that these regulatory proposals may resolve.

These recommendations are based on the belief that the tax law should be as unintrusive as possible in divorce and separation and be both simple and equitable in all areas, especially those involving homes. Further, when individuals fail to make affirmative choices, the defaults imposed by law and regulation should be fair. Moreover, heightened understanding of our tax laws will improve both the level of taxpayer compliance, as well as ease the IRS’s job of tax administration.

I hope you will give these proposals favorable consideration. I would be happy to meet with you or your staff to discuss these matters. In addition, the AICPA has offered to be of assistance, so if you have any specific questions about these proposals, feel free to contact: Michael E. Mares, Chair, AICPA Tax Executive Committee; Ward M. Bukofsky, Chair, AICPA Individual Taxation Committee, at (310) 278-5850; or Eileen R. Sherr, AICPA Technical Manager, at (202) 434-9256.

 

Sincerely,

 

The Honorable Barbara A. Mikulski (D-MD)

 

cc: Robert H. (Buff) Miller, Acting Deputy Tax Legislative Counsel for Regulatory Affairs, Dept. of Treasury, Room 4206

 

Proposal for Addition to Reg. § 1.163-8T(m)(1)

Regarding: Coordination of interest deductions on interspousal notes with other provisions

 

COMMENTS

Clarification is required regarding the treatment of interest on interspousal notes issued to effectuate a divorce settlement. Section 1041 states that no gain or loss shall be recognized on a transfer of property incident to divorce and such transfer shall be treated as a gift. However, if a note is issued to effectuate the transfer, then interest on such note should be allocated in accordance with the use of the debt. Accordingly, the interest allocation rules of section 163 should apply.

 

RECOMMENDATION

Reg. § 1.163-8T(m) should be amended as follows (new language is underlined):

(m) Coordination with other provisions. (1) Effect of other limitations. (i) In general. All debt is allocated among expenditures pursuant to the rules in this section, without regard to any limitations on the deductibility of interest expense on such debt. The applicability of the passive loss and nonbusiness interest limitations to interest on such debt, however, may be affected by other limitations on the deductibility of interest expense.

For purposes of Reg. § 1.163-8T, the treatment of a transaction under section 1041 should be treated as a sale or exchange with respect to the underlying note. If an asset is transferred incident to divorce and debt has been incurred to effect the transfer, such transfer shall be deemed to be an acquisition transaction with respect to allocating interest to such debt.

 

REASON FOR CHANGE

Reg. § 1.163-8T requires debt to be allocated in accordance with the use of debt proceeds. Reg. § 1.163-8T(c)(3)(ii) further provides that debt incurred in consideration for property should be treated as if the taxpayer used that debt amount to make an expenditure for such property. The above addition to the regulations would clarify that the section 1041 transfer of property is a sale or exchange for purposes of Regs. § 1.163-8T and § 1.163-10T, thereby requiring interest paid or accrued on notes issued incident to divorce to be classified according to the rules that we previously discussed in our recommendations. Thus, treatment as a sale or exchange of property in a section 1041 transaction for purposes of section 163 would eliminate the questionable treatment of interest on a transaction to acquire different types of property regardless of the personal nature of the divorce which originally caused the transaction to take place.

 

Proposal for Addition to Reg. § 1.163-8T(m)(2) and Reg. § 1.163-10T(b)

Regarding: Coordination of the interest expense allocation rules with section 265

 

COMMENTS

Reg. § 1.163-8T(m)(2) provides rules coordinating the interest expense allocation rules with other limitations that may be imposed by the Internal Revenue Code. This section states that IRC section 265 determines if debt is allocated to tax exempt investments regardless of the allocation provided by regulations under section 163.

It should be clarified that borrowings which are allocated to trade or business (including passive) expenditures or personal residence expenditures under the general rules of Reg. § 1.163-8T(c) should not be subject to the further limitations of section 265. The section 265 limitations should only apply to interest which has been first allocated under the general allocation rules as investment interest.

 

RECOMMENDATION

Make the following changes to Reg. § 1.163-8T(m)(2) (new language is underlined):

(2) Effect on other limitations -- (i) General Rule. Except as provided in paragraph (m)(2)(ii) of this section, any limitation on the deductibility of an item (other than the passive loss and non-business interest limitations) applies without regard to the manner in which debt is allocated under this section. Thus, for example, interest expense treated under section 265(a)(2) as interest on indebtedness incurred or continued to purchase or carry obligations (tax exempt assets) the interest on which is wholly exempt from federal income tax is not deductible regardless of the expenditure to which the underlying debt is allocated under this section.

However, interest expense which is allocated under paragraph (c) to trade or business expenditures or qualified residence expenditures under Reg. § 1.163-10T shall not be subject to the section 265 limitations unless the taxpayer also purchased tax exempt assets within 30 days before or after the qualified residence or trade or business expenditure, and either:

(A) Tax exempt assets were used as collateral for the debt, or

(B) The taxpayer’s primary motive for using debt for the qualified residence or trade or business expenditure was to carry tax exempt assets.

 

Make the following changes to Reg. § 1.163-10T(b) (new language is underlined):

(b) Treatment of qualified residence interest. Except as provided below, qualified residence interest is deductible under section 163(a). Qualified residence interest is not subject to limitation or otherwise taken into account under section 163(d) (limitation on investment interest), section 163(h)(1) (disallowance of deduction for personal interest), section 263A (capitalization and inclusion in inventory costs of certain expenses) or section 469 (limitations on losses from passive activities). Qualified residence interest is subject to the limitation imposed by section 263(g) (certain interest in the case of straddles), section 264(a)(2) and (4) (interest paid in connection with certain insurance), section 265(a)(2) (interest relating to tax-exempt income -- See Reg. § 1.163-8T(m)(2) for detailed discussion of this issue), section 266 (carrying charges), section 267(a)(2) (interest with respect to transactions between related taxpayers) section 465 (deductions limited to amount at risk), section 1277 (deferral of interest deduction allocable to accrued market discount), and section 1282 (deferral of interest deduction allocable to accrued discount).

 

REASON FOR CHANGE

Under the existing rules of section 265 and Rev. Proc. 72-18, the taxpayer is denied a deduction for interest that is allocated to the purchase or carrying of tax-exempt securities. Rev. Proc. 72-18 provides general rules regarding this allocation. The courts have generally held that debt that can be directly traced to the purchase of trade or business assets or a personal residence is exempt from this type of allocation, unless it can be determined that the predominant motive for utilizing debt is to avoid disposing of tax exempt securities. [See Wisconsin Cheeseman, Inc. (68-1 USTC 9145) and Illinois Terminal Railroad Company (67-1 USTC 9374)]

Rather than use the tracing rules to reinforce the predominant motive criterion of existing case law, the present wording of Temp. Reg. § 1.163-8T(m)(2) creates further uncertainty. Taxpayers who act in good faith to acquire a personal residence or trade or business assets should be given a safe harbor under these tracing rules.

Clarification of this position would be in the best interest of taxpayers and the government.

 

Proposal for Changes to Reg. § 1.163-10T(p)(3)(iii)

Regarding: The definition of "Use as a residence"

 

COMMENTS

A former spouse who is required, as part of a divorce settlement, to continue to pay the mortgage on the former marital residence is not entitled to an interest deduction under the qualified residence rules of section 163(h)(3) because, as to such spouse, the residence does not meet the definition of residence under section 280A as required in section 163(h)(4).

 

RECOMMENDATION

Reg. 1.163-10T should be amended by adding a second paragraph to regulation section 1.163-10T(p)(3)(iii) as follows (new language is underlined, deleted language is ):

(iii) Use as a residence.

(1) If a residence is rented at any time during the taxable year, it is considered to be used as a residence only if the taxpayer uses it during the taxable year as a residence within the meaning of section 280A(d). If a residence is not rented at any time during the taxable year, it shall be considered to be used as a residence. For purposes of the preceding sentence, a residence will be deemed to be rented during any period that the taxpayer holds the residence out for rental or resale or repairs or renovates the residence with the intention of holding it out for rental or resale.

(2) For purposes of this paragraph, a dwelling will be deemed to have been used as a residence by the taxpayer if the dwelling is used by a former spouse of the taxpayer and could have been selected by the taxpayer as a qualified residence for the taxable year in question if it were not for the dissolution of the marriage.

(3) If the use of a residence meets the requirements of paragraph (2), the holding out of the residence for resale shall not be considered to be a rental activity.

 

REASON FOR CHANGE

This change is needed to correct an inequity that exists when a former spouse pays the mortgage and does not reside in the dwelling which is occupied by the other former spouse of that marriage. Also, the resale of a former marital residence is a common event and the regulation should be amended to delete "holding out for resale" as a rental activity.

 

Proposal for Change to Reg. § 1.163-10T(r)

Regarding: Treating interest on debt secured by the taxpayer's qualified residence to effect transfer(s) of property incident to divorce

 

COMMENTS

Internal Revenue Service Notice 88-74, 1988-2 C.B. 385, states that regulations will provide that "debt incurred to acquire the interest of a spouse or former spouse in a residence, incident to divorce or legal separation, will be eligible to be treated as debt incurred in acquiring a residence for purposes of section 163, without regard to the treatment of the transaction under section 1041 of the Internal Revenue Code."

Regulations should also provide for treatment of debt incurred to acquire the interest of a spouse or former spouse, incident to divorce or legal separation, in property other than a residence, when such debt is secured by the spouse's remaining interest in a dwelling which could have been selected by the taxpayer as a qualified residence if it were not for dissolution of the marriage.

 

RECOMMENDATION

Current Reg. § 1.163-10T(r) should be renumbered as Reg. § 1.163-10T(s). A new Reg. § 1.163-10T(r) should be added as follows (new language is underlined):

(r) Qualified residence interest. The term "qualified residence interest" includes any interest which is paid or accrued during the taxable year on indebtedness which is incurred incident to divorce or legal separation (as defined in section 1041(c)) and which may be treated as:

(1) Acquisition indebtedness, if secured by the taxpayer's qualified residence and incurred to effect a transfer of spousal interest (as defined in (3) below) in such residence, or

(2) Home equity indebtedness, if secured by a residence and

(i) Meets the use requirement of section 280A as defined in Reg. § 1.163-10T(p)(3)(iii) and

(ii) Such debt was incurred to effect a transfer of a spousal interest in property other than such residence.

(3) The term "spousal interest" shall mean the ownership as determined by title to the property, unless the court of law adjudicating the marital dissolution attributes a different share in that property as part of the divorce settlement.

(s) Effective date. The provisions of this section are effective for taxable years beginning after December 31, 1986.

 

REASON FOR CHANGE

If debt is incurred either through a third party or by issuance of one or more interspousal, notes in exchange for an interest in marital property that is being transferred incident to divorce, then the obligor has incurred a debt in consideration for that property. As such, if the debt is secured by a perfected security interest in a qualified residence, and it is such residence that is being acquired, then such debt is "acquisition indebtedness" within the meaning of Internal Revenue Code section 163(h)(3)(B). This recommended change to the regulations will satisfy the intent of Notice 88-74 to provide clarification regarding debt incurred to acquire a spousal interest in a residence, incident to divorce.

If debt is incurred incident to divorce either through a third party or by issuance of one or more interspousal notes, and such debt is used to transfer property of the marital dissolution, then there is an acquisition of such marital property. However, if there is a perfected security interest on one spouse's remaining interest in a marital residence in order to transfer other property of the marriage, the interest paid or accrued on such debt should be allowed as home equity indebtedness.

 

Proposal for Additions to Regulations under I.R.C. §§121 and 1034

Regarding: Allocation of Sales Proceeds from Sale of Principal Residence Incident to Divorce

 

COMMENTS

Rev. Rul. 74-250 indicates that the gain from the sale of a jointly owned principal residence by a divorced couple will be allocated one-half to each, irrespective of how the proceeds are actually divided. Thus, taxability of proceeds will ordinarily follow legal title. The same result would occur for purposes of I.R.C. §§1034 and 121. It is thus possible for a taxpayer to unwittingly incur a significant tax or reinvestment requirement on the receipt of a small amount of proceeds.

It is recommended that the Service promulgate a regulation to make it clear that the tax consequences which follow from a divorced couple’s sale of their principal residence will be allocated in the same manner in which the net sale proceeds are allocated. This would require tax consequences to follow the economics of a transaction; further, those parties without competent tax advice would be protected from unintended tax hardship. This can be accomplished by adding new subsections to the regulations issued under I.R.C. §§121 and 1034 as follows.

 

RECOMMENDATION

Add the following subsection to both sets of regulations issued under I.R.C. §§121 and 1034.

Allocation of sales proceeds and basis for transfers to third parties incident to a divorce. In the case of a sale or exchange of a principal residence jointly owned by spouses or former spouses and (a) the net sales proceeds are allocated between the parties by a divorce decree or separation agreement and (b) the allocation is not in proportion to record ownership of the residence, the net sales proceeds and basis shall be allocated for purposes of this section according to the divorce decree or separation agreement unless an election to allocate sales proceeds in proportion to record ownership interests is made. "Net sales proceeds" shall mean the amount realized reduced by any debt repayments and any customary adjustments (including adjustments for real estate taxes, utilities, or similar items) paid from the gross proceeds.

Debt repayments shall be a reduction only to the extent of acquisition and home equity indebtedness (as those terms are defined in I.R.C. section 163(h)(3)). For purposes of this section, the limitations in I.R.C. sections 163(h)(3)(B)(ii) and 163(h)(3)(C)(ii) will not apply. Net sales proceeds includes cash received by the parties plus cash paid to third parties on behalf of the respective spouses (or former spouses). The amount realized by each spouse or former spouse shall be an allocation of the total amount realized in the same proportions as the allocations of net sales proceeds. Basis shall be allocated between the two parties in the same percentages of total basis as the allocation percentages of the amount realized. In all cases, the divorcing spouses may elect to allocate sales proceeds in proportion to their record ownership interests. Such election shall be made on Form 2119 at any time before the expiration of the period for which an amended return may be filed.

 

The provisions of this subsection are illustrated by the following examples:

Example (1): A and B are in the process of getting divorced. They jointly own a principal residence, with a basis of $50,000. The residence is sold for $200,000; selling expenses are $10,000; and mortgage loans totaling 90,000 are repaid from the gross sales proceeds. The parties agree that B is to receive all but $10,000 of the remaining $100,000. In this example, the net sales proceeds are $100,000. 10% is allocated to A; 90% is allocated to B. The amount realized is $190,000 which is allocated $19,000 to A and $171,000 to B. The basis will be similarly allocated: $5,000 to A and $45,000 to B.

Example (2): Assume the same facts as Example (1) except that the agreement between A and B states that $20,000 of A's legal fees and $5,000 of B's credit card debts will be repaid from the residence sales proceeds. The remaining $75,000 will be allocated 10% to A and 90% to B. The net sales proceeds are $100,000. A's share is $7,500 plus $20,000 (legal fees) or 27.5%; B's share is $67,500 plus $5,000 (credit card debts) or 72.5%. Thus, the amount realized and basis will be allocated in the ratios of 27.5% to A and 72.5% to B.

 

REASON FOR CHANGE

Divorcing taxpayers who sell their jointly-owned principal residences often allocate net sales proceeds very differently from an equal division. Those who are wealthy enough to receive expert tax advice may be told to re-title the house in proportion to the division of the net sales proceeds. The proposed change is intended to have taxability follow economic results. Currently, a taxpayer who received more than 50% of net proceeds will use Rev. Rul. 74-250 to his or her advantage while the other spouse may take a more aggressive position and report only proceeds received. As a result, the Government is whipsawed.

In addition, a recent case not involving a principal residence illustrates the uncertainty in allocating ownership of assets divided in divorce. In that case, the Third Circuit ordered that allocation of stock sales proceeds follow "beneficial ownership" rather than record ownership. Yonadi v. Commissioner, 21 F.3d 1292 (1994); 94-1 USTC par. 50,183.

 

This proposal would not resolve all such conflicts, but it would significantly reduce their number.