local law, a buyer does not acquire legal title to a residence he has purchased by means of debt until the debt is fully paid is not intended to have the result that the debt is treated as not secured by the residence, for purposes of this provision. Qualified residence interest is not subject to the limitation on personal interest even though the borrowed funds are used for personal expenditures.

Residences of the taxpayer.-The taxpayer's principal residence is intended to be the residence that would qualify for rollover of gain under section 1034 if it were sold. A principal residence may be a condominium or cooperative unit. 63 A dwelling unit will qualify as a residence only if it meets the requirements for use as a residence under section 280A. A second residence of the taxpayer includes a dwelling unit used by the taxpayer as a residence within the meaning of section 280A (gain on which could qualify for rollover treatment under section 1034 if the residence were used as a principal residence). If a second residence is not rented at any time during the taxable year, the taxpayer need not meet the requirement of section 280A(d)(1) that the residence be used for personal (nonrental) purposes for the greater of 14 days or 10 percent of the number of days it is rented.64 In the case of a joint return, a second residence includes a residence used by the taxpayer or his spouse and which is owned by either or both spouses.

Qualified residence interest may include interest paid by the taxpayer on debt secured by a residence of the taxpayer that he owns jointly or as a tenant in common, provided that all the requirements for qualified residence interest are met.

Qualified residence interest not treated as personal interest under the provision may include all or a portion of the interest on debt secured by the taxpayer's stock in a housing cooperative unit that is a residence of the taxpayer, or by his proprietary lease with respect to the unit. In addition, qualified residence interest not treated as personal interest under the provision may include all or a portion of the taxpayer's share under section 216 of interest expense of the housing cooperative allocable to his unit and to his share of common residential (but not commercial) areas of the cooperative. In applying the qualified residence interest exception where the taxpayer's residence is a cooperative housing unit, it is intended that regulations will be issued providing that the basis and fair market value limitations will apply in such a way as to achieve a result comparable to that which would occur if the taxpayer owned his share of the assets of the cooperative directly.

In the case of housing cooperatives, debt secured by stock held by the taxpayer as a tenant-stockholder is treated as secured by the residence the taxpayer is entitled to occupy as a tenant-stockholder. Where the stock may not be used as security by virtue of restrictions arising, for example, pursuant to local or State law, or pursuant to reasonable restrictions in the cooperative agreement, the stock may be treated as securing such debt, if the taxpayer es

63 A principal residence may also include a houseboat or house trailer. See Treas. Reg. sec. 1.1034-1(c)(3).

"A technical correction may be needed so that the statute properly reflects this intent. Such a correction was included in the versions of H. Con. Res. 395 that passed the House and the Senate in the 99th Congress.

tablishes to the satisfaction of the Internal Revenue Service that the debt was incurred to acquire the stock.

In the case of a husband and wife filing separate returns, each spouse may deduct interest on debt secured by one residence. Alternatively the spouses may consent in writing to allow one spouse to claim interest on debt secured by two residences at least one of which is a principal residence. In the latter case, any interest of the other spouse on debt secured by a residence is treated as interest which may be subject to disallowance.

In the case of a taxpayer who owns more than two residences, the taxpayer may designate each year which residence (other than the taxpayer's principal residence) the taxpayer wishes to have treated as the second residence.

Amount of limitation.-Qualified residence interest is calculated as interest on debt secured by the residence, up to the amount of the basis of the residence, plus the amount incurred after August 16, 1986, for qualified medical and educational expenses. If the amount of any debt incurred on or before August 16, 1986, and secured by the residence on August 16, 1986 (reduced by any principal payments thereon) exceeds the taxpayer's basis for the residence, then such amount (reduced by any principal payments thereon) shall be substituted for the taxpayer's basis in applying the preceding sentence. Increases after August 16, 1986 in the amount of debt secured by the residence on August 16, 1986 (for example, in the case of a line of credit) are treated as incurred after August 16, 1986. Thus, interest on outstanding debt secured by the taxpayer's principal or second residence, incurred on or before August 16, 1986, is treated as fully deductible (to the extent the debt does not exceed the fair market value of the residence), regardless of whether the borrowed funds are used for personal expenditures. Interest on debt secured by the taxpayer's principal or second residence, incurred after August 16, 1986, which debt exceeds the taxpayer's basis in the residence, is allowed only if the debt is incurred for qualified medical or educational expenses.

For purposes of determining qualified residence interest, the amount of the taxpayer's basis is determined without taking into account adjustments to basis under section 1034(e) (relating to rollover of gain upon the sale of the taxpayer's principal residence), or 1033(b) (relating to involuntary conversions). The basis for the residence includes the cost of improvements to the residence that are added to the basis of the residence.65 The taxpayer's basis is determined without regard to other adjustments to basis, such as depreciation. Thus, for example, if a taxpayer's second residence is rented to tenants for a portion of the year, and its basis is reduced by deductions for depreciation allowed in connection with the rental use of the property, the amount of his basis for the residence is not reduced by such deductions for purposes of this provision. Where the basis of a residence is determined under section 1014 (relating to the basis of property acquired from a decedent), the basis under this provision is the basis determined under section 1014 (plus the cost of home improvements made by the taxpayer

65 In the case of a home improvement loan, it is intended that the basis limitation under this provision will be adjusted to reflect the use of the loan proceeds for home improvements.

that are included in basis). In general, under this provision, the amount of debt on which the taxpayer may deduct interest as qualified interest will not be less than his purchase price for the residence.

Generally, interest on debt secured by the taxpayer's principal or second residence (up to the amount of the taxpayer's basis) is treated as qualified residence interest. Thus, for example, if the taxpayer's basis in his principal residence is $100,000 (and this amount does not exceed fair market value), and the residence is secured by debt in the amount of $60,000, interest on a refinancing for a total of $100,000 (including the original $60,000 plus an additional $40,000) is treated as qualified residence interest, regardless of the fact that the borrowed funds are used for personal expenditures by the taxpayer.

Qualified medical expenses are those amounts paid for medical care within the meaning of sec. 213(d)(1)(A) and (B) (not including amounts paid for insurance covering medical care under sec. 213(d)(1)(C)), of the taxpayer, his spouse and dependents.

Qualified educational expenses are those amounts paid for reasonable living expenses while away from home, and for any tuition and related expenses incurred that would qualify as scholarships (under sec. 117(b) as amended by the Act), for the taxpayer, his spouse or dependent, while a student at an educational organization described in section 170(b)(1). Thus, tuition expenses for primary, secondary, college and graduate level education are generally included in qualified educational expenses. The qualified educational expenses or qualified medical expenses must be incurred within a reasonable period of time before or after the debt is incurred. Medical or educational expenses that are reimbursed are not intended to be treated as qualified medical or educational expenses.

Interest on debt that is used to pay qualified medical or educational expenses, to be deductible as qualified residence interest, must be secured by the taxpayer's principal residence or second residence. Interest expense is so treated if the debt is so secured at the time the interest is paid or accrued.

Effective Date

The investment and personal interest limitations, as amended by the Act, are effective for taxable years beginning on or after January 1, 1987, regardless of when the obligation was incurred. The limitations are phased in. The personal interest limitation and the investment interest limitation are each phased in separately at the same rate.

Investment interest.-Under the Act, the amount of investment interest disallowed during the phase-in period is generally the sum of (i) the amount of investment interest that would have been disallowed under prior law plus (ii) the applicable portion of the additional amount of investment interest that would be disallowed once the provision is fully phased in. The amount of passive losses allowed under the passive loss phase-in rule (supra) that are sub

tracted from investment income are subject the investment interest phase-in applicable percentages.6 66

The applicable percentage under the investment interest phasein rule is 35 percent in 1987, 60 percent in 1988, 80 percent in 1989, 90 percent in 1990 and 100 percent in 1991 and thereafter. Thus, for example, if an individual taxpayer has $20,000 of investment interest expense in excess of investment income in 1987, 35 percent of the amount that does not exceed $10,000 or $3,500, plus the amount in excess of the $10,000 allowance would be disallowed. Thus, $13,500 would be disallowed, and $6,500 would be allowed for 1987 (assuming the taxpayer had no net passive loss for the year). With respect to the investment interest limitation, for taxable years beginning on or after January 1, 1987 and before January 1, 1991, the amount of net investment income is reduced by the amount of losses from passive activities that is allowed as a deduction by virtue of the phase-in of the passive loss rule (other than net losses from rental real estate in which the taxpayer actively participates). For example, if a taxpayer has a passive loss which would be disallowed were the passive loss rule fully phased in (as in taxable years beginning after December 31, 1990), but a percentage of which is allowed under the passive loss phase-in rule, the amount of loss so allowed reduces the amount of the taxpayer's net investment income under the investment interest limitation for that year.

Further, any amount of investment interest that is disallowed under the investment interest limitation during the period that the investment interest limitation is phased in (that is, taxable years beginning on or after January 1, 1987 and before January 1, 1991) is not allowed as a deduction in a subsequent year except to the extent the taxpayer has net investment income in excess of investment interest in the subsequent year.67

Personal interest.-The limitation on personal interest is phased in over the same period and applying the same percentages as for the investment interest limitation. No carryforwards are permitted for disallowed personal interest.

Revenue Effect

This provision is estimated to increase fiscal year budget receipts by $620 million in 1987, $4,511 million in 1988, $6,260 million in 1989, $8,370 million in 1990, and $9,597 million in 1991.

66 A technical correction may be needed so that the statute properly reflects this intent. Such a correction was included in the versions of H. Con. Res. 395 that passed the House and the Senate.

67 For example, assume that, in 1987, the taxpayer has a passive loss of $80,000 of which $30,000 is attributable to rental real estate activities in which the taxpayer actively participates. Assuming the taxpayer is entitled to deduct $25,000 of active rental losses, then 35 percent of the remaining $55,000, or $19,250, would be suspended under the passive loss limitation. Of the deductible $35,750 of passive losses, the portion not attributable to active rental activities reduces the taxpayer's net investment income under the investment interest limitation for 1987. That portion is determined by first calculating the ratio of (1) the amount of 1987 losses that are not attributable to rental real estate activities in which the taxpayer actively participates ($50,000) to (2) the amount of 1987 losses that are subject to the passive loss phase-in rule ($55,000). The ratio is applied to the total amount of passive losses allowed in 1987, other than those allowed under the $25,000 allowance ($35,750), to determine the portion allowed under the passive loss phase-in rule. This portion (i.e., $32,500) is subtracted from the amount of net investment income, under the investment interest limitation phase-in rule.

TITLE VI-CORPORATE TAXATION

A. Corporate Tax Rates (Sec. 601 of the Act and sec. 11 of the

Code) 1

Prior Law

Under prior law, corporate taxable income was subject to tax under a 5-step graduated rate structure. The top corporate tax rate was 46 percent on taxable income over $100,000. The corporate taxable income brackets and tax rates were as set forth in the table below.

This schedule of corporate tax rates was originally enacted in the Economic Recovery Tax Act of 1981 (ERTA), effective for 1983 and later years. For 1982, the applicable rates were 16 percent for taxable income not over $25,000, and 19 percent for taxable income over $25,000 but not over $50,000. For taxable years after 1978 and before 1982, the rates were 17 percent and 20 percent, respectively, for the lowest two brackets.

An additional 5-percent corporate tax was imposed on a corporation's taxable income in excess of $1 million. The maximum additional tax was $20,250. This provision phased out the benefit of graduated rates for corporations with taxable income between $1,000,000 and $1,405,000; corporations with taxable income in excess of $1,405,000, in effect, paid a flat tax at a 46-percent rate. This provision was enacted in the Deficit Reduction Act of 1984, effective for taxable years beginning after 1983.2

1 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 301; H.Rep. 99-426, pp. 231-233; H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 601; S.Rep. 99-313, pp. 219-221; and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 158-159 (Conference Report).

2 Under prior and present law, rules are provided in the Code to prevent the benefits of graduated rates from being proliferated through the use of multiple, commonly controlled corporations (secs. 1551, 1561-1564). Other statutory provisions attempt to limit the use of corporations to avoid the imposition of individual income tax. These are principally the accumulated earnings tax (sec. 531 et seq.), the personal holding company tax (sec. 541 et seq.), and certain personal service corporation provisions (sec. 269A).

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