AICPA

TAX DIVISION

 

INTEREST EXPENSE

LEGISLATIVE RECOMMENDATIONS

 

Approved by the

Individual Taxation Committee

and the

Tax Executive Committee

  

October 23, 1996

 

NOTICE TO READERS

 

This report is published for the information of members of the American Institute of Certified Public Accountants (AICPA) and constitutes an official position of the AICPA Tax Division and the Institute. It contains recommendations developed by the Interest Expense Task Force and Individual Taxation Committee, and approved by the Tax Executive Committee in October 1996.

 

Tax Executive Committee
1995-1996

Deborah Walker, Chair

Michael Mares, Vice Chair

Henry Ferrero, Jr.

Robert Holman

David Kautter

A.M. (Tony) Komlyn

Daryl Jackson

David Lifson, Committee Liaison

C. Ellen MacNeil

Robert Petersen

Robert Pielech

Kevin Reilly

Jay Starkman

Samuel Starr

Caroline Strobel

Gerald Padwe, Vice President, Taxation

Edward Karl, Director, Taxation

William Stromsem, Director, Taxation

 

Individual Taxation Committee

1995-1996

Ward Bukofsky, Chair

Chris Breeden

Ann Brooks

Gary Fox

L. Michael Gracik, Jr.

Nicholas Lascari

Nadine Lee

Douglas McCulley

David McDaniel

Donald Meidinger

Patricia Nielsen

Thomas Reardon

Don Scotto, Task Force Liaison

Eileen Sherr, Technical Manager, Taxation

Interest Expense Task Force

William McDermott, Chair

Alan Alport

Gerald M. Flynn, Jr.

Patricia Hale (1993-1994)

Kenton Klaus

Ilene Persoff

Kenneth Strauss

Eileen Sherr, Technical Manager, Taxation

 

INTEREST EXPENSE

LEGISLATIVE RECOMMENDATIONS

 

 

TABLE OF CONTENTS

 

I. Executive Summary (with Advantages and Disadvantages)
II. Basic Proposal
III. Home Equity Transition Rule
IV. Tax-Exempt Interest Proposal

 

 

INTEREST EXPENSE LEGISLATIVE RECOMMENDATIONS

 

I. Executive Summary

Under current law, an individual taxpayer must allocate interest expense among six possible categories (not including interest which must be capitalized): business (including passive), investment, qualified residence (acquisition related), qualified residence (home equity), personal, and interest attributable to acquiring or carrying tax-exempt securities (§ 265). The determination of the treatment of an individualís interest expense is often difficult both because of the number of possible categories and the complexity of the allocation methods.

In addition to the complexity of the current system, which results in some degree of noncompliance (whether or not intentional), it is susceptible to manipulation by sophisticated taxpayers, is difficult to administer by the IRS, is unfair in the sense that the same type of interest expense may be deductible by one taxpayer but not another, and may encourage uneconomic behavior.

We attempted to devise a legislative alternative to the current system which would be fairer, simpler, easier to administer, and less susceptible to manipulation.

 

This Legislative Proposal reduces the number of categories of individual interest expense from six to three:

1. Qualified Residence Interest Expense (related to acquisition indebtedness and home equity interest only to the extent used to substantially improve the home).

2. Business Interest Expense (including passive interest and home equity interest to the extent used for business expenditures).

3. Pool Interest Expense - includes what is now investment interest, personal interest, home equity interest (to the extent not used to substantially improve the home or for business expenditures), and interest attributable to acquiring or carrying tax-exempt securities.

 

The characteristics of pool interest expense are as follows:

1. It would be deductible as an individual itemized deduction to the extent of net investment income (NII, as currently defined) plus a standard allowance (N).

2. The excess of pool interest expense over NII plus N would be eligible to be carried over to future years.

3. Home equity interest expense, other than on debt related to the substantial improvement of the home or business expenditures, would be afforded a five-year transition rule to ease the burden of reclassifying it from qualified residence interest expense to pool interest expense. Basically, in addition to NII, the taxpayer would be allowed the greater of: (a) a declining percentage of grandfathered home equity interest expense, or (b) the standard allowance (N).

4. Tax-exempt investment income would be a direct reduction of pool interest expense available for deduction.

 

Advantages and Disadvantages of the Proposal

 

Advantages

1. The proposal simplifies the current structure by reducing the number of categories of interest expense, thus reducing the compliance burden, as well as the motivation and ability to "game" the system by manipulating the allocation of interest among the various categories.

2. Since money is fungible, there is no logical reason for not allowing a deduction for personal interest expense when a taxpayer has taxable investment income of an equal or greater amount. The proposal cures this illogical result by allowing a deduction for pool interest expense to the extent of net investment income plus a standard allowance. This removes the possible motivation to sell, solely for tax purposes, income-earning assets to pay down personal debt.

3. Including interest expense on home equity debt in the pool (other than debt used to improve the residence, which would continue to be deductible as qualified residence interest expense, or debt traceable to business expenditures, which would continue to be deductible as business interest expense) enhances the equitable treatment of taxpayers by treating all personal interest the same, whether the debt is secured by a personal residence or not. This levels the playing field among homeowners with sufficient equity in their homes, homeowners without such equity, and non-homeowners, without diminishing the motivation to purchase or improve a home since interest on acquisition indebtedness would continue to be separately deductible. Those who have relied on home equity interest would hopefully have a relatively painless transition given the transition rule and the standard allowance amount (N), which would ideally cover the vast majority of taxpayers with home equity loans.

4. The ambiguities and lack of compliance with respect to existing section 265 would be eliminated since net tax-exempt investment income would be a direct reduction of the pool interest expense available for deduction.

5. The proposal may discourage the uneconomic and sometimes risky behavior of borrowing against oneís home to pay personal expenses simply because the interest is deductible.

6. The proposal may encourage savings since pool interest expense would be deductible to the extent of net investment income plus the standard allowance amount (N); the greater the net investment income, the greater the interest expense deduction.

7. The proposal eliminates some of the present complex differences between qualified residence interest expense for regular tax and home mortgage interest expense for alternative minimum tax.

 

Disadvantages

1. The proposal would cause more people to itemize their deductions and would require those who already itemize to go through additional calculations to determine the amount of pool interest expense deductible. These changes could be perceived as additional complexity.

2. The proposal contains a transition rule with respect to interest expense on home equity debt. Transition rulesgenerally add complexity in the periods in which they apply.

3. The proposal may encourage consumer borrowing since a portion of personal interest expense may become deductible.

4. Unused pool interest expense (amounts in excess of net investment income plus the standard allowance amount (N)) would be carried over to future years until utilized, which could be perceived as additional complexity.

5. The provision relating to the treatment of net tax-exempt investment income (i.e., net tax-exempt investment income would reduce the amount of pool interest expense available for deduction) may have an unsettling influence on debt markets since it may in some cases be somewhat more difficult for an investor to readily compare the after-tax yield of a taxable security to a tax-exempt security. This would affect only the population of individuals with both net tax-exempt income and pool interest expense.

6. The provision relating to tax-exempt investment income may cause complications on state income tax returns since federal and state tax-exempt investment income amounts are often different. This would affect only the population of individuals with both net tax-exempt income and pool interest expense.

7. The proposal could be politically difficult if perceived as anti-homeowner due to the change in treatment of home equity interest.

 

II. Basic Proposal

 

Present Law

With the enactment of the Tax Reform Act of 1986, determining the deductibility of interest under the Internal Revenue Code has become an inordinately complex chore. Under present law, individual taxpayers are required to determine the type of interest expense incurred to determine if they have deductible or non-deductible interest. Extremely complicated tracing rules are used to allocate individual interest expense among six interest categories (not including interest which must be capitalized): business (including passive), investment, qualified residence (acquisition related), qualified residence (home equity), personal, and interest attributable to acquiring or carrying tax-exempt securities (§ 265).

Correctly determining the type of interest subjects taxpayers to difficult questions of allocation , and the sheer magnitude of record keeping required can be overwhelming.

The many statutes, regulations, and accompanying rulings serve only to mystify rather than to clarify. It has been found that the short term effect of this condition is to frustrate both the legitimate compliance attempts of taxpayers, as well as the administrative efforts of the government. In the longer term, the inability to comprehend and apply the rules may lead to contempt of, and disrespect for, our unique self-assessment system.

In general, the current interest deduction rules are overly complex, have inconsistencies, and result in inequitable treatment. They provide many traps for the unwary, while allowing opportunities for manipulation by other taxpayers. The rules often lead to either unfair tax consequences or uneconomic behavior by individual taxpayers.

 

Suggested Change

The proposal would reduce the total individual interest expense categories to three -- business, qualified residence acquisition indebtedness, and pool interest expense. The existing rules for business (passive and active) interest expense and qualified residence interest expense (as it applies to acquisition indebtedness) would remain.The proposal would create a pool for all other types of interest expense. The pool of all other interest expense would consist of what is currently defined as: investment interest expense, home equity indebtedness interest expense (other than amounts used to substantially improve the home or used for business expenditures), and personal interest expense. Taxpayers would deduct from the total amount of the pool their net tax-exempt investment interest income. Pool interest expense, as defined above, would only be deductible to the extent a taxpayer has net investment income (NII) plus a standard allowance amount (N). The standard allowance amount (N) would be an adjustable number (that would only be adjusted at most every three years, taking into account inflation), derived based on revenue and policy needs (possibly a number in the $3,000 to $7,000 range). NII would not be less than zero. Pool interest expense in excess of the current year deduction limit would be able to be carried over to future years until utilized . The IRC section 68(c)(2) investment interest exception to the overall 3% limitation on itemized deductions would be expanded to include pool interest expense.

Pass-through entities would not be affected by this proposal, and would continue to report interest expense (e.g., related to debt-financed distributions, as discussed in Notice 89-35, 1989-1 C.B. 675) to the individual partners/shareholders, who would then apply the proposal rules. Under the proposal, there would be no alternative minimum tax adjustment for qualified residence interest expense.

This proposal would be effective for all interest expense paid or accrued after the enactment date (i.e., the loan dates would not matter).

 

Reason for Change

The proposal simplifies the current complicated structure by reducing the number of categories of interest expense, thus reducing the compliance burden and the ability of individual taxpayers to manipulate the interest allocation rules. The proposal would also encourage individuals to enter transactions based only on economic, and not tax, purposes. The proposal would discourage the uneconomic and sometimes risky behavior of borrowing against oneís home to pay personal expenses simply because the interest is deductible. The proposal enhances the equitable treatment of taxpayers by treating all personal interest the same, whether the debt is secured by a personal residence or not. This levels the playing field among homeowners with sufficient equity in their homes, homeowners without such equity, and non-homeowners. In addition, the complicated section 265 tax-exempt income rules would be easier for taxpayers to understand and adhere to, and for the IRS to administer and enforce.

 

III. Home Equity Transition Rules

 

Present Law

Under present law, taxpayers are entitled to deduct "qualified residence interest" which is paid or accrued during the taxable year on both their acquisition indebtedness and home equity indebtedness with respect to any qualified residence.

Home equity indebtedness is defined as any indebtedness (other than acquisition indebtedness) secured by a qualified residence, provided the amount of indebtedness does not exceed the fair market value of the residence, reduced by the amount of acquisition indebtedness with respect to such residence. Further, the amount of any home equity indebtedness for any period shall not exceed $100,000 ($50,000 in the case of a separate return for a married individual).

 

Suggested Change

In general, home equity interest expense would no longer be deductible as qualified residence interest expense, but would be included in the pool. Exceptions would be: 1) interest expense on home equity debt used to substantially improve the home, and 2) interest expense on home equity debt traceable to business expenditures (under the existing tracing rules). Any such home equity indebtedness in existence at the date of enactment would be classified as "Grandfathered Home Equity Indebtedness" (GHEI). The pool interest expense for the first 5 years would be deductible to the extent of NII plus the greater of: the standard allowance amount (N) or a declining amount of interest expense on GHEI (100% of interest expense on GHEI for year 1, 80% of interest expense on GHEI for year 2, 60% of interest expense on GHEI for year 3, 40% of interest expense on GHEI for year 4, 20% of interest expense on GHEI for year 5, and 0% of interest expense on GHEI for year 6 and thereafter). Pool interest expense in excess of the current year deduction limit would be able to be carried over to future years until utilized

 

Reason for Change

Including interest expense on home equity debt (other than interest expense on amounts borrowed to improve the residence, which would continue to be deductible as qualified residence interest expense, or for business expenditures, which would continue to be deductible as business interest expense) in the pool interest expense enhances the equitable treatment of taxpayers by treating all personal interest the same, whether the debt is secured by a personal residence or not. This levels the playing field among homeowners with sufficient equity in their homes, homeowners without such equity, and non-homeowners, without diminishing the motivation to purchase or improve a home since interest on acquisition indebtedness would continue to be separately deductible. Those who have relied on home equity interest expense would hopefully have a relatively painless transition given the transition rule and the standard allowance amount (N), which would ideally cover the vast majority of taxpayers with home equity loans.

Regarding home equity interest expense, statistics (from the Center for Financial Services Studies - UVA McIntire School of Commerce) show that the average home equity line is about $35,200. However, the average amount of the home equity line in use is only about $21,600. Use of home equity lines in 1994 were as follows:

Home Equity Line 1994 Usage
Debt Consolidation 30%
Home Improvement (QRI) 22%
Auto & Other major purchases 14%
Business 7%
Investment 6%
Education 8%
Medical, Vacation and all other 13%

Total (note: 29% would not be in the pool, 71% in the pool) 100%

 

As can be seen above, 78% of all home equity funding is used for other than home improvement, with 7% used for business. Assuming a 10% interest rate, the average home equity interest expense is about $2,160 annually. Since the characteristics of home equity debt are substantially similar to personal interest, it is appropriate to treat this as a pool item, but allowing a reasonably generous transitional rule so that individuals locked into home equity loans can adjust their finances.

According to statistics from the Center for Financial Services Studies - UVA McIntire School of Commerce, the average age of a home equity loan is about five years. Accordingly, it is believed that five years is an appropriate transition period.

 

IV. Tax-Exempt Interest Proposal

 

Present Law

Under section 265, a taxpayer is not allowed a deduction for interest expense allocable to income which is exempt from federal income taxes. The regulations under this section and Rev. Proc. 72-18 generally provide rules for allocating debt between such investment and other activities of the taxpayer.

 

Suggested Change

Interest expense associated with tax-exempt securities would be included in the pool interest expense available for deduction. However, such pool interest expense amount would be reduced by net investment income from all tax-exempt securities owned by the taxpayer. For example, if an individual had $3,000 of pool interest expense and $1,000 of net investment income from tax-exempt securities, the individual would only be able to deduct a maximum of $2,000 of pool interest expense.

 

Reason for Change

Section 265 and related guidance provided by Treasury have created much controversy. As a result, compliance with these rules is inconsistent among taxpayers who borrow to finance tax-exempt securities. Further, it is unlikely that taxpayers who incur debt for other expenditures routinely consider the impact of rules that require an allocation of such debt to the "carrying" of tax-exempt securities. Clearly, in these situations, it can never be determined with any certainty the true motivation for incurring debt; and it is likely that there are occasions when the intent of the law is ignored and form over substance dictates the tax treatment.

By including all investment interest expense (including interest related to tax-exempt securities) in the pool, the taxpayer would not be required to apply complicated portfolio allocation rules prescribed under section 265. The proposal resolves the current conflict between the interest tracing rules under section 163 and the "carrying" of tax-exempt securities rules under section 265.

In addition, a reduction of the pool interest expense amount by net tax-exempt investment income provides a mechanism for accomplishing Congressí intent that interest to carry tax-exempt securities should not provide a tax benefit. This reduction is much easier to administer than the current complicated rules of section 265. It also eliminates the need to choose among various alternative allocation techniques that may have an arbitrary relationship to the actual economic motivations of the taxpayer.