result of having two eligible children. Because the phaseout of the child credit starts at $110,000 of modified AGI for a married taxpayer filing jointly, the child credit is not reduced by the phaseout. As a result of having no gross income, the taxpayer has no taxable income and thus no U.S. income tax liability to apply the $2,000 credit towards. Because the refundable child credit is based on only the portion of earned income that is included in taxable income for a taxpayer with fewer than three children, the taxpayer is not eligible for a refundable credit because none of the earned income is included in taxable income. Thus, the taxpayer with the lower income is denied the refundable credit, while the taxpayer with higher income receives a refundable credit. Most observers would agree that present law, in providing a refundable credit to certain high-income taxpayers, while denying it to certain lower-income taxpayers, violates generally held principles of equitable tax policy. Hence, the proposal adopts the EIC rule and prohibits claiming a refundable credit when the section 911 exclusion is taken. In general E. Repeal the Deduction for Interest on Home Equity Indebtedness (sec. 163) Present Law 118 In general, an individual may not deduct personal interest. Personal interest is any interest other than interest incurred or continued in connection with the conduct of a trade or business (other than the trade or business of performing services as an employee) or investment interest. Qualified residence interest, however, is not treated as personal interest and is deductible subject to limitations.119 Qualified residence interest means interest on either acquisition indebtedness or home equity indebtedness. Acquisition indebtedness Acquisition indebtedness is indebtedness incurred in acquiring, constructing or substantially improving any qualified residence of the taxpayer. Acquisition indebtedness is reduced as payments of principal are made and cannot be increased by refinancing. Thus, for example, if the taxpayer incurs $200,000 of acquisition indebtedness to acquire his principal residence and pays down the debt to $150,000, his acquisition indebtedness with respect to the residence cannot thereafter be increased above $150,000 (except by indebtedness incurred to substantially improve the residence). Refinanced acquisition debt continues to be treated as acquisition debt to the extent that the principal amount of the refinancing does not exceed the principal amount of the acquisition debt immediately before the financing. The indebtedness must be secured by the qualified residence and is limited to $1 million. Qualified residence means the taxpayer's principal residence and one other residence of the taxpayer selected to be a qualified residence. Home equity indebtedness Certain home equity indebtedness may give rise to deductible qualified residence interest. Home equity indebtedness, for this purpose, means debt secured by the taxpayer's principal or second residence to the extent the aggregate amount of such debt does not exceed the difference between the total acquisition indebtedness with respect to the residence, and the fair market value of the residence. The amount of home equity indebtedness on which interest is treated as deductible qualified residence interest may not exceed $100,000 ($50,000 for married persons filing a separate return). 120 120 Sec. 163(h)(2)(D) and (h)(3). The $100,000 limitation on home equity indebtedness was enacted by the Revenue Act of 1987. The Tax Reform Act of 1986 had previously limited the deductibility of personal interest. The exception in the Tax Reform Act of 1986 for qualified residence interest allowed a 121 Interest on qualifying home equity indebtedness is deductible, regardless of how the proceeds of the indebtedness are used. A taxpayer and a mortgage company can contract for the home equity indebtedness loan proceeds to be transferred to the taxpayer either in a lump sum payment or a series of payments (e.g., a reverse mortgage). Thus, under present law, the total amount of a taxpayer's home equity indebtedness with respect to his principal residence and a second residence, when combined with the amount of his acquisition indebtedness with respect to such residences, may not exceed a $1,100,000 overall limitation ($550,000, for married persons filing a separate return). Reasons for Change The present-law deduction for interest on home equity indebtedness is inconsistent with the goal of encouraging home ownership while limiting significant disincentives to saving. A taxpayer may deduct interest on a loan of up to $100,000 secured by his residence that has no relation to the acquisition or substantial improvement of the residence. This acts as a disincentive to savings and is unrelated to the purpose of encouraging home ownership. Further, the present-law home equity indebtedness rules provide inconsistent treatment by allowing deductible interest for homeowners' consumption spending that is not allowed to similarly situated non-homeowners. Description of Proposal The proposal repeals the deduction for interest on home equity indebtedness. Effective Date The proposal is effective for interest paid on debt incurred after the date of enactment. Interest on home equity indebtedness originally incurred before the date of enactment and refinanced on or after the date of enactment remains deductible only to the extent of the outstanding principal of the indebtedness at the time of refinancing. The following examples illustrate the application of the effective date: Example 1.-A taxpayer has a home with a fair market value of $500,000 in a taxable year beginning after the date of enactment. The taxpayer has a first mortgage of $250,000 (at 6.5 percent) which qualifies as an acquisition loan. The taxpayer has a home equity loan of $75,000 (at seven percent) but pays no interest during the year. Both the $250,000 first mortgage and the $75,000 home equity loan were originally incurred before the effective date. After the date of enactment, the taxpayer incurs a new home equity loan of $225,000 (at six percent) and pays off deduction for interest on a loan secured by a principal or second residence up to the sum of the amount of the cost of the residence plus the amount of qualified medical expenses and qualified educational expenses (not in excess of the fair market value of the residence). 121 Examples of such personal expenditures include health costs and education expenses for the taxpayer's family members or any other personal expenses. the $75,000 home equity loan. The taxpayer may continue to deduct the interest on the first mortgage of $250,000 as an acquisition loan and may also deduct one-third of the interest of the new home equity loan ($75,000/$225,000). Example 2.-Same facts as above except that the taxpayer did not have an outstanding home equity loan on the date of enactment. The taxpayer may continue to deduct the interest on the first mortgage of $250,000 as an acquisition loan, but none of the interest on the new home equity loan. Discussion In general Encouraging savings is a policy goal reflected throughout the Code. In part for this reason, personal interest generally is not deductible. Another policy reflected in the Code is the promotion of home ownership. To promote home ownership, the Code allows a deduction for qualified residence interest (including interest on home equity indebtedness). Interest on home equity debt, however, more closely resembles non-deductible personal interest than interest incurred to purchase a taxpayer's principal or second residence, and therefore the general tax policy against subsidizing personal debt (other than for homeownership) should apply to home equity indebtedness. There are three major arguments for eliminating the deduction for home equity debt: (1) it creates conflicting policies; (2) it causes complexity in the tax law; and (3) it yields disparate treatment of similarly situated taxpayers. Conflicting policies If a tax deduction for personal interest were allowed, it would reduce the effective interest cost of the indebtedness and thereby encourage individuals to incur such debt. By generally disallowing a deduction for personal interest, present law discourages personal debt of individuals and encourages personal saving. Because home equity interest is interest paid on a personal debt, allowing a deduction for such interest creates an inconsistent policy as between home equity debt and other personal debt. Further, it is unlikely that the deduction for interest on home equity debt significantly adds to the present-law incentive to encourage homeownership because most decisions to purchase a home are unlikely to be affected by the ability to deduct home equity indebtedness. Also, individuals who currently benefit from the home equity debt rules have already achieved homeownership and are unlikely to stop being homeowners because the home equity debt rules are repealed. Complexity 122 The present-law rule that home equity interest is only deductible for indebtedness up to the amount that the fair market value of the home exceeds acquisition indebtedness adds complexity to the tax law by requiring the homeowner to determine the fair market value of the home on a periodic basis. This source of complexity is compounded in periods of fluctuating 122 The deduction for interest on home equity indebtedness may conflict with the goal of homeownership if taxpayers are encouraged to incur unsustainable levels of debt. real estate prices. Repeal of the home equity debt rules would eliminate this source of complexity. Further, the present-law home equity debt rules can be manipulated by taxpayers. For example, many automobile dealerships are willing to accept a security interest in a car buyer's home without any information about the home's value or whether the home is security for any other debt in order to provide the individual with an interest deduction under the home equity debt rules. Dealers may take this interest in the home though a security interest in the car as their primary security on the debt (often making the home as security for the debt in form only). The result of this inconsistency can be a perception that the tax rules are unfair as well as complex. The present-law home equity debt rules have some simplification value in certain circumstances. Specifically, when the amount of home equity indebtedness incurred as part of a home refinancing does not exceed $100,000, a taxpayer may not have to allocate interest because all the interest on the home refinancing is deductible. Unlike present law, the proposal requires a taxpayer to bifurcate the interest paid on the refinancing debt between the deductible and nondeductible portions if any home equity debt (other than grandfathered home equity debt) is incurred as part of a refinancing. Therefore the proposal can result in additional computational complexity in certain circumstances. However, this potential increase in complexity is small compared to the reduction in complexity related to valuation that would be effected by the proposal. 123 In determining how to characterize interest expense of an individual as, for example, investment interest (which is deductible within certain limits) or personal interest (which generally is nondeductible), or deductible qualified residence interest (including home equity interest), temporary regulations provide rules that essentially adopt a tracing approach. These tracing rules could be simplified by reducing the number of categories of interest to which they apply. Denying deductibility for home equity debt rules would simplify the tracing and reduce complexity. Disparate treatment of similarly situated taxpayers Home equity debt is often incurred to finance an individual's personal expenditures, and not to finance homeownership. Such interest would be nondeductible as personal interest if it were not incurred with respect to home equity debt. Effectively, present law gives unequal treatment for otherwise similar interest costs based on whether the debtor owns a home. This result is inequitable. The home equity deduction also treats homeowners unequally because the present-law home equity debt rules favor homeowners with equity in their home versus homeowners with little or no equity. Therefore, this tax benefit generally is more valuable to homeowners in areas with price appreciated homes than to homeowners in areas with flat or declining home prices. Taxpayers may respond to the proposal by incurring or maintaining larger amounts of acquisition indebtedness. If this occurs, disparate treatment of similarly situated taxpayers may continue. |