NEW YORK CITY BAR PROPOSES SIMPLIFYING INTEREST DEDUCTION FOR INDIVIDUALS.

The committee's report points out that the current rules are complex and are "frequently a trap for the ill-advised taxpayer." On the other hand, the current rules also "fail to eliminate opportunities for manipulation by the well-advised taxpayers."

The proposal basically would set up three categories of interest. First, interest on acquisition indebtedness would remain deductible and would be treated as it is under current law. The second category would include investment interest, personal interest, interest on home equity indebtedness, and home mortgage interest that is not treated as qualified residence interest (because the interest exceeds the deductible amount). The deduction of the interest expense in this "other interest" category would be limited to the greater of (1) net investment income (which would have the same definition as under current law) or (2) a minimum dollar amount (to allow taxpayers the ability to deduct some interest expense in years little or no investment income). Excess interest expense from this category could be carried forward indefinitely. Business and passive activity interest would make up the proposal's third category and would remain subject to current law.

As presiding Chair of the Committee on Personal Income Tax of The Association of the Bar of the City of New York, I enclose our Committee's report outlining a proposal to simplify interest deductions for individuals.

Under the proposal, business interest, passive activity interest, and qualified residence interest would remain deductible in accordance with existing law. Other interest, such as investment interest and personal interest, would be combined into one category. Interest on home equity indebtedness, which has recently been the subject of much criticism, and qualified residence interest in excess of the deductible amount, would be treated like personal interest and included in this category. Interest in this category would be deductible to the extent of net investment income, or a minimum dollar amount, if greater. Excess interest expense could be carried forward indefinitely.

The proposal would achieve simplification by reducing the number of interest categories and thereby lessening the need for tracing rules. In preparing these recommendations, the Committee also bought to minimize any adverse impact on the fisc and to avoid significant impact on any particular segment of taxpayers.

Sincerely yours,

Proposal to Simplify Interest Deductions for Individuals ¹

SUMMARY

In order to comply with the different limitations under Section 163 of the Internal Revenue Code ("Code"), an individual taxpayer must allocate his or her interest expense among the following categories: ²

trade or business interest investment interest passive activity interest qualified residence interest personal interest

Temporary Regulations provide complex rules which endeavor to "trace" debt proceeds (and hence the related interest) based on how the proceeds are spent. Since money is fungible, these rules are complex, frequently a trap for the ill-advised taxpayer, and fail to eliminate opportunities for manipulation by the well-advised taxpayer.

In order to reduce this complexity and the inequities that result, we make the following recommendations with regard to the interest deduction for individuals:

A. INTEREST ON ACQUISITION INDEBTEDNESS would remain deductible in accordance with existing law. Interest on an obligation secured by a taxpayer's home that is not treated as acquisition indebtedmess interest (i.e., interest on home equity indebtedness and interest expense in excess of the deductible amount) would constitute "Other Interest," as described below.

B. OTHER INTEREST would include present-law investment interest, personal interest, interest on home equity indebtedness and home mortgage interest not treated as qualified residence interest. All such interest would be deductible to the extent of a limitation equal to the greater of (i) net investment income (as defined under existing law) or (ii) a minimum dollar amount, so as to provide a taxpayer with the ability to deduct a limited amount of interest expense in years in which the taxpayer has little or no net investment income. Any excess interest expense would be carried forward indefinitely; any unused portion of the minimum dollar amount would not.

C. BUSINESS INTEREST AND PASSIVE ACTIVITY INTEREST would remain subject to existing law.

In making its recommendations, the Committee has attempted to eliminate as many interest categories as possible with a view to reducing the need to apply the "tracing rules," achieving simplification and fairness in application while minimizing any adverse impact on the fisc and any significant impact on any particular segment of taxpayers.

DISCUSSION

I. Present Law.

A. BUSINESS INTEREST: Interest allocable to a trade or business activity which is not classified as a passive activity is fully deductible.

B. QUALIFIED RESIDENCE INTEREST: Interest on up to $1 million of "acquisition indebtedness" secured by, and incurred in acquiring, constructing, substantially improving, or refinancing a principal or second residence is deductible. Code Sections 163(h)(3)(B); 163(h)(4)(A). Interest on up to $100,000 of "home equity indebtedness" secured by a principal or second residence is deductible regardless of whether such debt qualifies as acquisition indebtedness. Code Sections 163(h)(3)(C); 163(h)(4)(A). Interest on pre-October 13, 1987 indebtedness secured by a principal or second residence may be deductible without limitation under special grandfather rules. Code Section 163(h)(3)(D).

C. INVESTMENT INTEREST: Interest on debt allocable to "property held for investment" is deductible to the extent of the taxpayer's "net investment income" for the taxable year. Code Section 163(d)(1). For this purpose, "property held for investment" includes (1) property which produces interest, dividends, annuities or royalties other than in the ordinary course of a trade or business, and (2) any interest in a trade or business activity in which the taxpayer does not materially participate and which is not a passive activity. Code Section 163(d)(5)(A). "Net investment income" generally is equal to "investment income" (i.e., gross income and net gain from property held for investment), less deductions other than interest which are directly connected with the production of investment income. Code Section 163(d)(4). Investment interest in excess of net investment income may be carried forward and deducted subject to the net investment income limitation in the carry-forward year. Code Section 163(d)(2).

D. PERSONAL INTEREST: Personal interest is not deductible. ³ Code Section 163(h)(1).

E. PASSIVE ACTIVITY INTEREST: Any interest taken into account to compute income or loss from a passive activity of the taxpayer, including interest on debt incurred to purchase an interest in a passive activity, is subject to the limitations on passive losses. Code Section 163(d)(3)(B)(ii).

F. TRACING AND ALLOCATION: The rules used to "trace" interest to one or more of the above categories are set forth in Temporary Regulations section 1.163-8T.

These rules are complex, and different tracing rules apply depending upon whether debt proceeds are disbursed directly to the borrower or to a person other than the borrower. For example, if a lender disburses debt proceeds directly to a seller of property rather than to the borrower (or if the taxpayer assumes a debt or takes property subject to a debt), interest paid or accrued on the debt is allocated as if the taxpayer expended debt proceeds directly for that purpose. In such an instance, the allocation process is fairly straightforward and depends upon how the taxpayer uses the debt-financed property. However, if debt proceeds are paid directly to the borrower who deposits them in an account before spending them, the allocation process is more complex: the proceeds initially are treated as property held for investment and the interest is treated as investment interest, whether or not the account bears interest. Debt proceeds, and thus the corresponding interest, are reallocated from the investment category to one of the other categories depending upon when and how the proceeds are expended. Expenditures from the account generally are considered to be made first out of the debt proceeds, regardless of whether the taxpayer deposited unborrowed amounts in the account before or after the debt proceeds were deposited.

Unless a loan is secured by the taxpayer's first or second home, the type of property which secures a debt is irrelevant for purposes of allocating interest. The Temporary Regulations also contain a number of complex elections which permit taxpayers easily to manipulate the tracing rules.

II. RECOMMENDATIONS.

The Committee recommends that interest paid or accrued by individuals be treated as follows: ⁴

A. INTEREST ON ACQUISITION INDEBTEDNESS would remain deductible in accordance with existing law. Interest on an obligation secured by a taxpayers home that is not treated as acquisition indebtedness (i.e., interest on home equity indebtedness and interest expense in excess of the deductible amount) would constitute "Other Interest," as described below.

B. OTHER INTEREST would include present-law investment interest, personal interest, interest on home equity indebtedness and home mortgage interest not treated as qualified residence interest. All such interest would be deductible to the extent of a limitation equal to the greater of (i) net investment income (as defined under existing law) or (ii) a minimum dollar amount, so as to provide a taxpayer with the ability to deduct a limited amount of interest expense in years in which the taxpayer has little or no net investment income. Any excess interest expense would be carried forward indefinitely; any unused portion of the minimum dollar amount would not.

C. BUSINESS INTEREST AND PASSIVE ACTIVITY INTEREST would remain subject to existing law.

The Committee does not intend that its proposal favor one group of taxpayers over another but, as indicated, offers these proposals as a basis for achieving some simplification. Ultimately, the enactment of these proposals must be balanced against any negative impact on the fisc, a determination that the Committee leaves to Congress and the Treasury.

III. REASONS FOR PROPOSED CHANGES.

The Internal Revenue Service and taxpayers have had over 30 years of experience with the tracing rules in the regulations under Section 265 (expenses and interest relating to tax-exempt income) and over 15 years of experience with the tracing rules in the regulations under Section 861 (determination of taxable income from U.S. and foreign sources). These two sets of tracing rules affect individuals or international businesses that generally can afford to consult tax advisers. Despite the attention that has been given to drafting these rules, taxpayers frequently orchestrate their investments to produce tax results almost as desirable as those produced if the tracing rules did not exist. Experience with the tracing rules of Sections 265 and 861 indicate that tracing rules are far too complicated for equitable impact, widespread understanding, voluntary compliance or efficient administration.

Unlike the limited group of taxpayers affected by the tracing rules under Sections 265 and 861, the burden of complying with the tracing rules under Section 163 is borne by a very different group of taxpayers, since these tracing rules have the potential to affect many taxpayers who may not otherwise need the assistance of a professional tax adviser. Unless a taxpayer consults a tax adviser upon or before the receipt of the proceeds of a loan, the taxpayer may well be unaware of the tracing rules and how these rules affect the deductability of an item of interest. Even if a taxpayer is aware of the need to comply with certain procedures in order to substantiate an interest deduction, the taxpayer is likely to need professional advice to comply with these procedures. It is impossible to determine how many taxpayers are unaware of the tracing rules, how many knowingly fail to comply, how many use some other method to allocate an item of interest, and how many believe they are entitled to deduct any interest as long as it does not exceed net investment income. Administrative complexity, taxpayer noncompliance, and a trap for the unwary would be substantially eliminated if personal interest were grouped with investment interest.

Moreover, high income taxpayers with sufficient liquidity are able to choose when to borrow and how to disburse debt proceeds so that interest will be allocated under the tracing rules to a category of deductible interest. High income taxpayers can afford to consult with tax advisers who can demonstrate that a legitimate tax advantage is obtained if, for example, the taxpayer disposes of investment assets purchased with unborrowed funds to fund the purchase of personal property and borrows to acquire similar investment assets (thereby substituting deductible investment interest for nondeductible personal interest). The Committee believes that the tracing rules have caused taxpayers to engage in such uneconomic behavior and should be eliminated to the extent feasible. ⁵

The effect of the tracing rules primarily appears to be to limit the interest deduction for middle income taxpayers, who generally are unable to structure their borrowing activities as can higher income taxpayers. Although it is arguable that the present law deduction for home equity indebtedness may eliminate the need to comply with the tracing rules for many middle income taxpayers by providing a means by which interest for personal items is deductible, the Committee believes that the home equity indebtedness rule unduly favors taxpayers who are homeowners and promotes uneconomic behavior. H.R. Rep. 100-391, 100th Cong., 1st Sess., pt. 2, at 1033 (1987), reprinted in 1987 U.S. Code Cong. & Admin. News 2313-649. Accordingly, the Committee favors the elimination of the separate home equity indebtedness deduction.

The Committee believes that a fairer approach would be to allow ALL taxpayers to deduct some dollar amount of Other Interest (as defined above) in any year in which the taxpayer has little or no investment income. Accordingly, the Committee's proposal would define net investment income as the greater of (i) net investment income (as defined under existing law) or (ii) a minimum dollar amount. All Other Interest, whether currently incurred or arising from a carryforward, would be deductible against that limitation. Excess interest would be carried forward indefinitely; any unused portion of the minimum dollar amount (or any unused portion of net investment income) would not. The Committee does not propose a specific dollar amount, but anticipates that the amount would be at least $2,000 but not greater than $10,000. The Committee notes that determination of this minimum dollar amount could be considered in conjunction with consideration of the extent and nature of any grandfather provision for existing home equity debt. ⁶

IV. PASSIVE ACTIVITY INTEREST.

The Committee examined whether interest presently categorized as "passive activity interest" might, to further the goal of eliminating as much of the need for tracing rules as possible, be combined with investment interest and personal interest in one basket. In particular, the Committee focused on interest incurred directly by an individual to invest (directly or through a pass-through entity) in a passive activity.

However, since the predominant form of direct borrowing for passive activity purposes would appear to involve direct investment in real estate, the Committee believes that liberalizing the deductability of direct passive interest would (i) be contrary to the legislative purpose behind the separate "basket" for passive activities, and (ii) create results which are inappropriate. For example, if a taxpayer has limited investment income and finances the purchase of a rental building, under existing law the taxpayer would offset the rental income from the building with the operating costs of the building, depreciation and interest. Since interest generally comprises a significant deduction against rental income, a change in characterization of that interest could, in some circumstances, have the effect, of creating nondeductible interest and taxable income on the passive activity. Although such problems might be alleviated by changing the definition of "net investment income" to include income from certain passive activities, the Committee believes, on balance that whatever simplicity in tracing might be gained by eliminating certain present law categories of passive activity interest are outweighed by the potential adverse effects of such a change.

V. EXAMPLES.

The following examples illustrate our recommendations. For purposes of the examples, we have assumed a minimum dollar amount for the "Other Interest" deduction of $3,000.

A. Jane Smith pays $40,000 of interest on a mortgage loan ($400,000 principal) used to acquire, and secured by, her principal residence. She has interest income of $4,000. She pays $6,000 of interest on credit cards. Jane may deduct her mortgage interest and $4,000 of her credit card interest; she has a $2,000 carryforward.

B. Bill Edwards pays $148,000 of interest on a mortgage loan ($1,480,000) used to acquire, and secured by, his principal residence. Bill has net investment income of $50,000. Bill pays $3,000 of interest on a debt incurred to purchase an automobile. Bill may deduct $100,000 of the interest on his mortgage as "qualified residence interest," and he may deduct, in the aggregate, $50,000 of his remaining mortgage interest and personal interest. Bill has a $1,000 carryforward.

C. Victoria Jones pays $10,000 of interest on a home equity line of credit. She has $1,000 of interest income from savings. Victoria may deduct $3,000 of her interest by virtue of the minimum dollar amount provision; $7,000 will be carried forward. In the subsequent year, Victoria pays no interest (ie., she pays off her home equity loan) and has no interest income. Victoria may, by virtue of the minimum dollar amount provision, deduct $3,000 of the interest expense carried forward from the prior year; the remaining $4,000 will be carried forward.

August 19, 1991

² There is an additional category of interest expense: interest on estate tax deferred payments. This category is not discussed herein.

³ This includes interest on a tax deficiency assessed against an individual taxpayer.

⁴ This report does not make any recommmendations with regard to transitional rules.

⁵ It may be argued that the Committee's recommendations favor high income taxpayers who are more likely to have substantial net investment income. However, as noted above, under the present rules many well-advised high income taxpayers can easily convert personal interest into investment interest.

⁶ For example, if Congress decides to give transitional relief to interest on home equity indebtedness, Congress could provide that such interest expense deduction would reduce or eliminate the minimum dollar amount.

* Ms. Schapiro died subsequent to the preparation of this proposal but prior to its submission to Treasury.