Does Ninth Circuit Mortgage Interest Decision Create Special Rights?

This post was originally published on Forbes Aug 19, 2015

It is kind of ironic for the Ninth Circuit, which played such a big role in advancing marriage equality, to be issuing a decision that discourages registered  domestic partners from marrying.  That is an effect of the decision in the case Bruce Voss and Charles Sophy vs IRS, although I imagine it is an unintended consequence.  It almost seems as if the Ninth Circuit has instituted that conservative trope - special rights for homosexuals - with this decision.  Closer analysis would show it would be more like special rights for homosexuals and geezers.

Home Mortgage Interest Limitation

The case is about the limitation on home mortgage interest.  Residence interest is deductible on a mortgage up to $1,000,000 that was used for acquiring or improving a residence and another $100,000 secured by the residence and spent any old way you want.  By the way, those numbers were set in 1987 and are not indexed for inflation.

That $1.1 million is the same whether you are a single person or a married couple filing a joint return.  If a married couple files separately they each get $550,000.  But what about two people who are not married who jointly own a residence?  Say a $3 million home with a mortgage of $2.5 million.  Do they each get to deduct the interest on $1.1 million or is the limit per house rather than per taxpayer?  That is what the Voss decision was about.  The IRS said the limit was per house and in 2012 the Tax Court agreed with the IRS.  The Ninth Circuit agrees with the taxpayers.  This decision has had enough coverage to incline me to skip it, but I would like to hone in on some of the aspects.

The Reasoning

The decision is a great example of Reilly's First Law Of Tax Planning - It is what it is. Deal with it. The IRS had argued that making the limit per taxpayer rather than per house created a marriage penalty.  That got the IRS a "So what?"

We thus agree that the debt limit provisions of § 163(h)(3) result in a marriage penalty; but we are not particularly troubled. Congress may very well have good reasons for allowing that result, and, in any event, Congress clearly singled out married couples for specific treatment when it explicitly provided lower debt limits for married couples yet, for whatever reason, did not similarly provide lower debt limits for unmarried co-owners. 

The IRS argues that applying § 163(h)(3)'s debt limit provisions on a per-taxpayer basis creates a marriage penalty. We agree that it does, but we do not believe the marriage penalty is as significant a concern as the IRS urges.

The Court went on from there to speculate on whether Congress was doing any thinking when it passed the law.

Of course, a married couple filing separate returns does not receive the benefits of filing a joint return. Is it unfair, then, that they are treated as a single taxpayer while the unmarried couple is not? Perhaps not, for the married couple, unlike the unmarried couple, can usually elect to file a joint return. And perhaps Congress did not want separately filing married couples to have a significant advantage over jointly filing married couples.

That's all well and good, but it glosses over something. Voss and Sophy were registered domestic partners in a community property state.  That means each is taxed on half of his own income and half of his partner's income.  That evening out of income is probably the major advantage of filing a joint return when compared to unmarried people filing as single. (There are a lot of disadvantages to filing separately if you are married, which makes this discussion a little confusing.)

Is Registered Domestic Partnership A Better Tax Deal Than Marriage?

Thanks to the Ninth Circuit's recent decision, there is now a new marriage penalty for couples with large mortgages.  The amount of the penalty depends on how much the mortgage exceeds $1.1 million, its interest rate and the marginal tax rate of the taxpayers.  My back of the envelope computation would put the maximum penalty at not a lot more than $20,000 (The Voss/Sophy Tax Court decision had total deficiencies of about $36,000 in 2006 and $22,000 in 2007, but it seems like there was a little more going on there than the definitional issue).

A committed unmarried couple who did some serious planning could really go to town exploiting the fact that they are considered unrelated for federal income tax purposes.  I got into that at some length back in 2010 with a post titled - Just Because They Won't Let You Do It Doesn't Make It A Good Idea.  For example if Robin owns high basis rental real estate and Terry owns low basis rental property and they want to sell Terry's property, they can do a like-kind exchange first which will allow Robin to use the higher basis on the sale.

Of course there are income tax advantages that go the other way. Married couples have the advantage of Code Section 1041 which allows them to swap any assets between themselves tax-free.  Employer paid heath insurance for a registered domestic partner can be taxable.  For the high net worth, the transfer tax (estate and gift) advantages of marriage might well trump any income tax advantages. All things considered, though, I think you will find that there are many couples for whom being registered domestic partners is a much better tax deal, particularly in community property states, where they get the benefit of income splitting without being stuck with a more onerous rate table.

What About Nontax Issues?

Under California law being in a registered domestic partnership is an awful lot like being in a marriage.

 Registered domestic partners shall have the same rights, protections, and benefits, and shall be subject to the same responsibilities, obligations, and duties under law, whether they derive from statutes, administrative regulations, court rules, government policies, common law, or any other provisions or sources of law, as are granted to and imposed upon spouses.

That's pretty sweeping.  Of course, the extent that it applies beyond the borders of California is pretty iffy.  I think though a couple that was pretty committed to California might want to look real hard at the net income tax cost of marriage, since, at least at home, they can have all the benefits of marriage through a registered domestic partnership, which brings us to the policy question.

Why Is This Great Deal Just For Gays And Geezers?

According to the official website, people frequently ask California Secretary of State Alex Padilla why only same-sex couples or opposite-sex couples in which at least one partner is at least 62 register as domestic partners. The answer is rather unsatisfying.

The eligibility criteria for registration of a domestic partnership is set by statute. The age eligibility of opposite sex couples requires that at least one partner be at least 62 and the age eligibility for same sex couples requires that both partners be over 18, or have obtained a court order granting permission to establish a domestic partnership.

In other words - "It is what it is.  Deal with it." I haven't studied the legislative history, but it seems likely that there was a little coalition building going on there when the registered domestic partnership concept was created, since it allows seniors to enter into a marriage-like arrangement without affecting their social security eligibility.

From a policy viewpoint, it would seem that there is no longer any rationale for having registered domestic partnerships as an alternative to marriage restricted to same-sex couples. As far as the planning opportunity that is presented, I'm not the first person whose mind this has crossed.  Last  year, in a piece titled - Are Domestic Partnerships A Way For Heterosexual Couples To Avoid The Marriage Tax Penalty? - Howard Gleckman wrote

We’ve known for a while that same-sex couples could choose a self-help solution to the marriage penalty that still allowed them most legal rights of marriage. But in at least some states opposite-sex couples can do the same. I don’t know if enough people will take advantage of this opportunity to create a revenue problem, but it bears watching.

I think the history is pretty clear that the registered domestic partnership concept was a reaction to the universal ban on same-sex marriage.  Now that the ban is gone, does the institution still have a valid function as a marriage alternative or will it turn into a technique for gaming the system?  If the latter, then let the games begin, that's how people like me make a living.

 Other Coverage

There is quite a bit of coverage of the Ninth Circuit decision including Joe Kristan and the TaxProf. Leslie Book at Procedurally Taxing noted that the Ninth Circuit indicated that little deference should be given to Chief Counsel Advice.