REVENUE RULE 95-53

1995-2 C.B. 30, 1995-34 I.R.B. 17

ANNUITY; MORTGAGE; INTEREST DEDUCTION

Released: August 2, 1995
Published: August 21, 1995

Section 264. - Certain Amounts Paid in Connection with Insurance Contracts, 26 CFR 1.264-2; Single premium life insurance, endowment, or annuity contracts.
Annuity; mortgage; interest deduction. If a taxpayer uses a single premium annuity contract as collateral to obtain or continue a mortgage loan, section 264(a) of the Code disallows the allocable amount of interest on the loan to the extent the loan is collateralized by the annuity contract. Rev. Rul. 79-41 clarified and superseded.

ISSUE

If a taxpayer uses a single premium annuity contract as collateral to obtain or continue a mortgage loan, does section 264(a)(2) of the Internal Revenue Code disallow an allocable amount of interest on the loan to the extent the loan is collateralized by the annuity contract?

FACTS

A, an individual, purchases a principal residence for $100,000 and purchases a single premium annuity contract for $15,000. A obtains a mortgage loan of $95,000 to finance the purchase of the residence and uses the annuity contract as additional collateral for the mortgage loan. The mortgage loan qualifies as acquisition indebtedness and the interest paid on the loan is qualified residence interest within the meaning of section 163(h).

The cash value of the annuity contract, when issued, is $15,000. Under the collateral agreement relating to the annuity contract, if A defaults on the mortgage loan, the lender may withdraw the cash value of the annuity contract up to $15,000 or the outstanding balance on the mortgage loan, whichever is less. Otherwise, A remains the owner of the annuity contract and, subject to the terms of the contract and applicable law, A may withdraw part of the cash value of the contract so long as the remaining cash value does not fall below $15,000.

LAW AND ANALYSIS

Section 163(a) allows a deduction for interest paid or accrued within the taxable year on indebtedness. Section 163(h) generally denies deductions for personal interest paid by taxpayers other than corporations but provides an exception for qualified residence interest.

Section 264(a)(2) provides that no deduction shall be allowed for any amount paid or accrued on indebtedness incurred or continued to purchase or carry a single premium life insurance, endowment, or annuity contract.

Section 1.264-2(a) of the Income Tax Regulations provides, in part, that amounts paid or accrued on indebtedness incurred or continued, directly or indirectly, to purchase or to continue in effect a single premium annuity contract are not deductible under section 163 or any other provision of chapter 1 of the Code.

In Rev. Rul. 79-41, 1979-1 C.B. 124, an annuity contract was used as collateral to borrow funds to purchase stock. Rather than liquidate the annuity contract for its cash surrender value, the taxpayer maintained the annuity investment by borrowing, using the annuity as collateral, and then purchasing the stock. Rev. Rul. 79-41 holds that, pursuant to section 264(a)(2), no deduction is allowable for interest paid on the loan because the use of the annuity as collateral is direct evidence of a purpose to carry the annuity contract.

Rev. Rul. 79-41 cites and relies on Wisconsin Cheeseman, Inc. v. United States, 388 F.2d 420 (7th Cir.1968). In that case, the court held that section 265(2) denied a deduction for interest paid on a loan where tax-exempt bonds were used as collateral for the loan. The court reasoned:

In this case, this nexus or "sufficiently direct relationship" is established by the fact that the tax-exempt securities were used as collateral for the seasonal loans. Under Section 265(2), it is clear that a taxpayer may not deduct interest on indebtedness when the proceeds of the loan are used to buy tax-exempts. 4A Mertens. Law of Federal Income Taxation (1966 ed.) s

26.13 and cases cited. Applying the rule that the substance of the transaction is controlling in determining the tax liability, the same result should follow when the tax-exempt securities are used as collateral for a loan. Surely one who borrows to buy tax-exempts and one who borrows against tax-exempts already owned are in virtually the sameeconomic position. Section 265(2) makes no distinction between them.

388 F.2d at 422. See also Rev. Proc. 72-18, 1972-1 C.B. 740, section 3.03.

The annuity contract that A purchased is used as collateral for the mortgage loan. Accordingly, under Wisconsin Cheeseman and Rev. Rul. 79-41, the use of the annuity contract as collateral is direct evidence that a portion of the mortgage loan was incurred to carry the annuity contract, and section 264(a)(2) applies.

HOLDING

If a taxpayer uses a single premium annuity contract as collateral to obtain or continue a mortgage loan, section 264(a)(2) of the Internal Revenue Code disallows the allocable amount of interest on the loan to the extent the loan is collateralized by the annuity contract. The allocable amount of interest expense disallowed is the current interest rate on the mortgage loan multiplied by the amount of the annuity contract used as collateral (or by the amount of the loan, if less).

In contrast to the situations in which an annuity is used as collateral for a loan, or a loan is otherwise incurred or continued to purchase or carry an annuity contract, section 264(a)(2) generally does not apply simply because (i) an individual uses available cash to purchase an annuity contract and as a result needs to take out a larger mortgage loan to purchase a residence, or (ii) an individual continues to hold an annuity contract rather than surrender it for its cash value when that surrender would make it possible to reduce the mortgage loan required to purchase a residence. In these situations, a purpose to purchase or carry an annuity contract cannot reasonably be inferred where the personal purpose of obtaining the mortgage loan is unrelated to the annuity contract and dominates the transaction. See Rev. Proc. 72-18.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 79-41 is clarified and superseded.

DRAFTING INFORMATION

The principal author of this revenue ruling is Melissa Luxner of the Office of the Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, contact Ms. Luxner on (202) 622-3142 (not a toll-free number).