It’s not just Death and Taxes that are certainties in life. Having lived through the economic downturns in 1973, 1981, 2001, and 2008, I now believe we can add Recessions to the list. And another one seems to be coming. So this may be a good time to pay attention to Ronald W. Howland, Jr. and Marilee R. Howland v. Commissioner, T.C. Memo. 2022-60 (June 13, 2022) (Judge Weiler), where we learn some of the obstacles taxpayers face in taking a §163 interest deduction when foreclosure proceeds only partially pay off a loan balance that includes principal and accrued interest.
In Howland, the Court did not permit any §163 deduction. This week and next I'm going to try something new and compare the Tax Court case with a recent Circuit Court case. I think the comparison is instructive. This week, we compare Howland to the recent 9th Circuit opinion in Milkovich v. U.S. 24 F.4th 1 (9th Cir. 2022), where the 9th Circuit did permit a §163 deduction from foreclosure proceeds. Both Howland and Milkovich arose from the Great Recession. Looking at the similarities and difference of the two cases gives us the lesson, which is in part a cautionary tale on how at least some of the obstacles to deduction may be self-created.
Details below the fold
Law: The Home Mortgage Interest Deduction and Partial Payments
Here are the relevant legal rules I think you need to know for today’s lesson.
Section 163(h)(2)(D) permits taxpayers to deduct “qualified residence interest.” As the term suggests, the deduction requires a “qualified residence” which can be either or both the taxpayer’s principal residence and one other residence that the taxpayer actually makes personal use of for the greater of 14 days or 10% of the days it’s rented out. §163(h)(4)(A), x-ref. to §280A(d)(1). Taxpayers can deduct interest only on qualified indebtedness. Before 2018 that two types of indebtedness (secured by a qualified residence). First was acquisition indebtedness. Taxpayers could deduct interest on the first $1m of such loans. Interest attributable to loan balances exceeding $1m were not deductible. Second was home equity indebtedness. Taxpayers could deduct interest on the first $100,000 of such loans. For tax years 2018 through 2025, however, Congress reduced the $1m cap to $750k, and eliminated the deductibility of interest on home equity loans. §163(h)(3)(F).
When a taxpayer sells a qualified residence (on which there is qualified indebtedness) for more than the loan balance, there is generally no difficulty in determining what amount of the proceeds are allocable to interest. Since the entire loan is paid off, we can say with certainty that all the accrued interest gets paid at the time of sale. Even when the taxpayer does not sell the residence but turns it over to the lender, if the fair market value of the residence is greater than the loan amount, then you have a full-pay situation.
The analysis gets a bit more complex when a taxpayers sells a qualified residence in a short sale—a sale that does not generate enough money to pay off the loan in full. “The general rule in the United States courts with regard to the application of a partial payment upon a debt is that it shall be first applied to the liquidation of the interest due, before any part is applied to the principal.” Helvering v. Drier, 79 F.2d 501, 503 (1935) (notice the date). That rule goes waaaay back. See Story v. Livingston, 38 U.S. 359 (1839). And that general rule can be altered by agreement of the parties. Drier, supra. We can generally use the same analysis when a lender forecloses the qualified residence. All we need to know for today's lesson is the well-settled rule that a foreclosure sale is deemed to be a sale or exchange made by the debtor of the encumbered property. See Helvering v. Hammel, 311 U.S. 504 (1941).
The first complexity is the nature of the debt. Is the debt recourse or nonrecourse? On the one hand, if the debt is recourse, then what the taxpayer is deemed to have paid over to the lender consists of the actual foreclosure proceeds. Whatever part of the loan that was not satisfied by the foreclosure is potentially Discharge of Indebtedness income. See Treas. Reg. 1.1001–2(a)(1), and -2(c)(2), Example (8). That not only puts additional weight on how the lender in fact applies the money, it also raises a potential application of §265(a) if the DOI is excluded from income under §108. That’s a rabbit trail we don’t need to follow today, however.
On the other hand, if the debt is nonrecourse, then the taxpayer is deemed to have received the full amount of the outstanding debt as a result of the foreclosure. Commissioner v. Tufts, 461 U.S. 300, 317 (1983) (when debtor sells property encumbered by nonrecourse debt, the amount realized by the debtor includes the full outstanding balance of the nonrecourse debt even if the liabilities exceed the fair market value of the property). Whether that results in income to the taxpayer depends, of course, on basis in the property foreclosed. But what it does mean is that we don’t have an actual full payment of the debt, we do have a deemed full payment of the debt. Thus, all of the accrued interest at time of foreclosure will be deemed paid and can generate a §163 deduction. While generally home mortgages are recourse loans, some state laws effectively convert them to nonrecourse loans in the event of a short sale. For a great illustration of how this works, see Catalano v. Commissioner, T.C. Memo. 2000-82 (2000), rev’d on other grounds, 279 F.3d 682 (9th Cir. 2002) (taxpayer’s home mortgage deemed nonrecourse under California law and therefore “under Tufts, the amount that the debtor realized upon the disposition of his residence in foreclosure included both the principal indebtedness and the interest that had accrued as of the foreclosure date.”).
A second complexity is insolvency. If the taxpayer is insolvent, then courts are reluctant to apply the interest-first rule. The Tax Court explained why in Newhouse v. Commissioner, 59 T.C. 783, 790 (1973):
“The significance of petitioner's insolvency cannot be minimized. What would be deductible by him as interest would similarly be includable in the bank's income as interest received. And we find it difficult to believe that a creditor who was foreclosed on the collateral of an insolvent debtor, and who will never get back the full amount of his principal, is required to report a fictitious amount of income designated as interest."
A final complexity is that foreclosure sale proceeds are not voluntary payments. So when the foreclosure proceeds constitute but a partial payment of the outstanding loan balance, someone has to figure out the extent to which that partial payment goes to interest. The general rule of allocation to interest first is seemingly based on the notion that the debtor has made a voluntary payment. Newhouse v. Commissioner, 59 T.C. 783, 789 (1973). Absent the general rule, or specific terms in the loan agreement, the lender can pretty much do what they want. Therefore, much depends on what the lender actually does with the money. If the lender allocates some of the proceeds to interest, then great! If not, then bummer! You can see how this entirely a question of fact.
In 2007, the Howlands took out a $390,000 home equity loan on their house in Florida. Under the terms of the loan, all payments were to be applied first to interest and only then to principal. Pretty standard stuff. First lien on the property was held by Countrywide.
Then the Great Recession hit. The Howlands stopped making payments on the home equity loan. The home equity lender went under and its assets were eventually acquired by First Southern Bank shortly before its merger with CenterState Bank. First Southern sued. The court permitted it to foreclose its junior lien. The outstanding balance was $377,000 on the loan. At the July 28, 2016 foreclosure sale CenterState was the highest bidder at $321,000. At that time, the amount of unpaid interest on the home equity loan was $100,600.
Meanwhile Countrywide’s first mortgage was acquired by Bank of New York Mellon. The opinion is silent on whether and to what extent the Howlands had continued paying their primary mortgage but apparently they had also stopped because on June 9, 2016 Mellon filed its own foreclosure action, claiming a balance due of $247,000 on the first mortgage. The opinion is silent on how that was divided between interest and principle or whether the Howlands ever claimed an interest deduction with respect to the first mortgage. The opinion is also silent on whether the July 2016 foreclosure paid off the Mellon loan or whether CenterState bought the property subject to the senior lien.
Whatever, CenterState-First Southern apparently worked out something with Mellon because CenterState then sold the house to unrelated third parties in December 2016 for $594,000 and everyone walked away, if not happy then at least relieved.
However, Judge Weiler is careful to note the absence of two facts. First, “There is no evidence in the record as to how the sale proceeds of $594,000 were applied to petitioners’ debts with First Southern Bank and Bank of New York Mellon.” Op. at 2. Second, “No Internal Revenue Service (IRS) Form 1098, Mortgage Interest Statement, was issued to petitioners for tax year 2016 for the home mortgage interest in question.” Those turn out to be important omissions.
As you and I know, third party information returns may or may not have any bearing on the proper calculation of tax. So here the lack of a Form 1098 did not prevent the Howlands from claiming a mortgage interest deduction for 2016. They claimed $103,500. I share Judge Weiler’s confusion on why the claimed deduction was different than the amount of unpaid interest on the home equity loan. See Op. at 7, note 6 (“Petitioners now contend that they are entitled to a QRI deductin of $1000,607. It remains entirely unknown how petitioners calculated their original claimed QRI deduction of $103,498.”). One guess is that the $3,000 difference might represent a claimed payment in 2016 for interest on the first mortgage.
As you and I also know, however, significant mis-matches between information returns and the taxpayer’s return can lead to receipt of an IRS love letter. So it happened here. Since the Howlands had claimed a substantial §163 deduction for mortgage interest payments but there was no supporting Form 1098, that caught the attention of the IRS computers and, eventually, a Revenue Agent (RA). The RA disallowed the deduction. She believed that since the $321,000 foreclosure bid “did not cover the principal balance due from petitioners to CenterState Bank, after payment of the first mortgage balance due to Countrywide Home Loans...no interest amount was paid to CenterState Bank at the time of the foreclosure sale.” Op. at 4.
Lesson: Self-Created Obstacles Trip Up Taxpayer’s Claimed §163 Deduction
Of the multiple complexities mentioned above, I think it was the last one that tripped up the taxpayers here. Let’s work through them.
First, there is little doubt that the Howlands’ home equity loan was recourse. I am guessing it was recourse, both because home equity loans generally are and because Judge Weiler’s analysis is the recourse loan analysis, looking to the actual foreclosure proceeds to determine how they were applied in a partial payoff of the debt.
Second, there is nothing in the record suggesting the Howlands were insolvent at the time of either foreclosure. So that gets them out of the Newsome problem. Op. at 6.
Third, since we have only an involuntary partial payment, you see how that raises the critical factual question of how First Southern and Mellon actually applied the proceeds from the two foreclosure sales. We have a partial payment. The general rule is interest first. And in this case, remember, the home equity loan agreement specifically provided that all payments were to be applied first to accrued but unpaid interest. So it seems a good argument for the taxpayer.
The taxpayers hung their hat on the loan agreement. They argued that since the agreement required payments to be applied first to interest, the Court should therefore hold the successors in interest to the original lender to that agreement and deem the allocation to have been so made.
I don’t think anyone would have criticized Judge Weiler for going there. Assuming that First Southern was bound by the agreement as a successor in interest to the original lender, I think it would be a defensible presumption that First Southern followed the agreement.
But neither should anyone criticize Judge Weiler for not going there. As he carefully explains multiple times in the opinion, taxpayers bear the burden of proving entitlement to a deduction. Included in that burden of proof is the burden of providing the court with sufficient evidence to show entitlement. The existence of a legal agreement is not proof that the agreement was followed. Judge Weiler writes:
“The record before us is silent as to how CenterState applied the funds received and whether petitioners owe any remaining principal balance. These facts (if favorable) could support a finding that petitioners in fact paid home mortgage interest (in some amount)—rather than repaying principal balance. However, statements in briefs do not constitute evidence.”
That’s the lesson. That’s the self-created obstacle. The taxpayers had it within their ability to show evidence of how CenterState actually applied the foreclosure proceeds in June. Even if not, they might still have been able to show that, at the time of the first foreclosure, the fair market value of the property exceeded both loan balances (the foreclosure sale itself would not be the only evidence of fair market value). If so, that could have been enough to meet their burden of proof. My thanks to Ken Weil for pointing that out to me and my apologies to Ken if I messed that up.
Comment 1: Contrast with Milkovich. In Milkovich v. U.S. 24 F.4th 1 (9th Cir. 2022) the taxpayers were underwater on their home and filed bankruptcy, apparently a no-asset Chapter 7. The discharge had the effect of converting their mortgage from recourse to nonrecourse and the lender agreed to a short sale of the property. Then lender then took the partial payment and applied it against both interest and principle and the taxpayers sought a §163 for the interest. Since it was a nonrecourse loan at that point, the court used the analysis that deems the amount received to be the full balance of the mortgage and not just the actual cash received. Thus “because, under Tufts, Plaintiffs are deemed at the short sale to have realized an amount that includes all of the discharged nonrecourse debt, including the accrued interest, they must for that further reason be deemed to have made the payment of interest that CitiMortgage received. And because Plaintiffs paid that mortgage interest, it was deductible under I.R.C. §163(a), (h)(2)(D), (h)(3).” 24 F.4th at 12. Alternatively, however, the Court also found for the taxpayers based on (1) a Form 1098 sent by the bank to the taxpayers stating the amount of interest paid; and (2) records from the bank showing its actual application of the foreclosure proceeds to interest first and only then to principal. So you see how the attorney in Miklovich did an excellent job in avoiding the self-created obstacle that tripped up the taxpayer in Howland.
Comment 2: Confusion on §163 limits. The deduction for qualified residential interest is not unlimited. When the qualifying indebtedness is a home equity loan, then only the interest on the first $100k is deductible. Here, since the Howlands’ loan amount was considerably above $100k, I admit confusion on how they could possibly claim an interest deduction of $100k. I would think it would have to be subject to the limits. See Catalano v. Commissioner, supra, where the Court allowed the interest deduction but limited it to the taxpayer’s first $1m of acquisition indebtedness. Since the taxpayers were denied any deduction I suppose it does not matter; but I’m still confused. I welcome enlightening comments from folks who might offer an explanation.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday to TaxProf blog for a new Lesson From The Tax Court.