Passive Activity Loss ATG - Exhibit 7.2: IRC § 469(j)(7) - Interest On Rental Residence
Publication Date - December 2004
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
Exhibit 7.2: IRC § 469(j)(7) - Interest On Rental Residence
ISSUE: Is interest expense on Schedule E deductible under IRC § 469(j)(7)? The IRC § 469(j)(7) and Reg. § 1.163-8T(m)(3) provide that passive activity losses will be computed without regard to qualified residence interest as defined in IRC § 163. A "qualified residence" as defined by IRC § 163(h)(5)(A)(i) is either a principal residence or a second residence.
NOTE: Qualified residence interest belongs on Schedule A and is therefore subject to the itemized deduction limitations.
_____ Verify that property is taxpayer's "principal residence". Reg. § 1.163-10T(p)(2) indicates that principal residence means principal residence as defined by IRC §1034. The taxpayer cannot have more than one principal residence at any one time. In Stolk V. Comm., 40 TC 345 , the taxpayer moved out of his principal residence two years prior to its sale, and the Court held that the property did not qualify as his principal residence. Similarly, in Friedman v. Comm., T.C. Memo 1982-178, the Court held that a residence used by the taxpayer only during the summer months cannot qualify as a principal residence.
If property is taxpayer's principal residence, skip the next step.
If it is not the taxpayer's principal residence, continue on.
_____ Verify that property is taxpayer's "second residence". If property is rented, Reg. § 1.163-10T(p)(3)(ii) states that it qualifies as a residence only if taxpayer used it personally for the greater of 14 days or 10 percent of days rented (IRC § 280A(d)).
QUESTION: How many days did you spend at the rental property during the year?
NOTE: In virtually all cases, box 2 on Schedule E has been checked NO, indicating that the taxpayer fails the requirements of IRC § 280A(d). Therefore, the property does not qualify as a second residence. If box 2 is YES and taxpayer spends more than 14 days, losses are limited IRC § 280A, i.e. expenses deductible up to rental income.
_____ Verify via review of bank statement and/or cancelled check that interest was actually paid in year deducted. If taxpayer fails qualified residence test OR cannot verify interest, disallow losses. If he passes, go to next step.
_____ Verify that interest expense qualifying under IRC § 469(j)(7), i.e. qualified residence interest, has been properly reflected on Schedule A as an itemized deduction. Some taxpayers have moved interest to another column on Schedule E, avoiding the itemized deduction limitations.
LAW: Qualified residential interest is claimed as an itemized deduction from adjusted gross income. The IRC §161 provides that deductions permitted by subtitle A, Ch. 1, Subchapter B, Part VI (itemized deductions), including interest deductions under 163, are taken in computing taxable income under 63. Therefore, it is improper for qualified residence interest to be claimed on Schedule E as a deduction from AGI.
CONCLUSION: Under IRC § 469(j)(7) and § 163(h)(5)(A)(i), taxpayer has/has not (circle one) verified the deductibility of qualified residence interest from property rented on Schedule E. OR
A personal residence is subject to the itemized deduction limitations on Schedule A, including the 3 percent phaseout for high income taxpayers. The IRC § 469 does not override other IRC sections. It is merely one of several IRC sections, which limit losses on a tax return. While § 469(j)(7) excepts qualified residence interest from the passive loss limitations, nowhere does the IRC, Regulations. or legislative history state or imply that home mortgage interest is not subject to the itemized deduction limitations. To the contrary, Reg. §1.469-1T(d) specifically provides that the application of IRC § 469 does not affect the treatment of items under any provision of the IRC other than IRC § 469. In other words, the mere fact that IRC § 469 permits deductibility does not mean that other IRC sections may not limit the interest expense. Qualified residential interest is claimed as an itemized deduction from adjusted gross income. The IRC §161 provides that deductions permitted by subtitle A, Ch. 1, Subchapter B, Part VI (itemized deductions), including interest deductions under 163, are taken in computing taxable income under 63. Therefore, it is improper for qualified residence interest to be claimed on Schedule E as a deduction from AGI. There is nothing in the language of the IRC, Regulations or committee reports to suggest that personal residence interest from a rented residence should be excepted from itemized deductions.