An Update on the Lawsuit Against Bank of America for Failing to Issue Accurate Interest Information Statements

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One of the most viewed posts last year was one that discussed a lawsuit alleging that Bank of America intentionally and systematically understated millions of dollars in homeowners’ mortgage interest payments following loan modifications. Today is the first of a two- part post by the lead lawyer on the case, David Vendler, a partner at Morris Polich & Purdy LLP. In this post, David updates us on developments in the case and related cases. In tomorrow’s post, David walks through in detail his legal arguments that underlie the claim that the bank has underreported interest.

David is an accomplished attorney who has been lead counsel in a number of high profile class action lawsuits. The charges in the Bank of America case relate to fundamental issues of tax administration, including whether consumers can rely on information returns that financial institutions issue. This post and tomorrow’s post show us that perhaps consumers and preparers may need to think twice about whether they can rely on those statements. In addition, there may be a need for millions of consumers to amend prior years’ returns when the returns include interest deductions when banks have modified loans. As David describes, the district court case that I originally discussed last year was dismissed, and now is on appeal. Related cases though are percolating, and it is likely as David describes the IRS and courts may be weighing in soon. Les

We are writing to update your blog on the status of our case against Bank of America, N.A. involving its failing to include on Forms 1098 customer payments of deferred interest in the loan modification context. As your readers will recall, the question at the heart of the case is whether 26 U.S.C. 6050H requires banks and mortgage servicing companies to report on Forms 1098 borrower repayments of interest that were owed at the time of a loan modification and which have been are “wrapped into” the “new principal” of the loan post-modification.

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An example was given in the earlier blog post that well illustrates the issue. Assume a homeowner facing financial distress has a $600,000 principal balance on a 15-year mortgage. At the time of the modification, the homeowner also owes $60,000 in delinquent interest. Post modification, the homeowner ends up with a 30-year mortgage and owes $660,000. That amount consists of the original principal plus the $60,000 in back interest. Our view is that the entirety of the borrowers’ post-modification payments should be applied first to retiring the $60,000 of pre-modification interest, and that those amounts should be reported on Form 1098. Bank of America and many other banks have taken the position that they are not going to report the repayment of this interest at all.

Our position is that pre-loan-modification interest retains its character as interest post-modification and that therefore 26 U.S.C. Section 6050H requires that the borrowers’ post-loan modification payment of that interest must be reported on Form 1098. We further take the position that under the “interest before principal” payment allocation provisions that exist in all standard mortgage agreements, the borrowers’ post-loan-modification payments should be first applied to retire any pre-modification interest. Only then, should payments be allocated to retiring interest accrued post-modification and principal. See Prabel v. Commissioner, 91 T.C. 1101, 1113 (1988), affd. 882 F.2d 820 (3d Cir.1989) (courts generally have “deferred to the loan agreements between debtors and creditors where the agreements make specific provision for the accrual or allocation of loan payments between principal and interest.”)

Last year, our case against Bank of America got thrown out by the district court (that dismissal is  here). The ground for the district Court’s opinion was that the IRS supposedly has “exclusive enforcement” jurisdiction over 26 U.S.C. Section 6050H. We have appealed that ruling and briefing on that appeal will be complete next month. Argument will likely take place sometime in 2017. In the months since our case against Bank of America was thrown out, two other district courts in similar cases have explicitly refused to follow the Bank of America decision and have found these other Form 1098 cases “cognizable” in court; those opinions are found here and here. In our view, these subsequent decisions by two different federal judges bode well for our chances before the 9th Circuit. But there are also other movements afoot that will have ramifications on this issue (and our appeal) within this year.

Although the IRS refused all of our entreaties to become involved with this issue (made through the Office of the Taxpayer Advocate), two banking industry submissions – made pursuant to Rev. Proc. 2003-36 on September 15, 2015 and October 15, 2015 by the Mortgage Bankers Association (“MBA”) (MBA letter here) and American Bankers Association (“ABA”) (ABA letter here) – have apparently gotten the IRS to finally take notice. Specifically, on January 7, 2016, the IRS as part the IRS’ Industry Issue Resolution Program issued a curt statement stating it had agreed to accept two issues for consideration: (1) whether Section 6050H requires reporting of pre-loan-modification interest and (2) whether deferred interest in the negative amortization loan context should be reported.

Not surprisingly, neither the AMA’s and MBA’s letters claim that such interest should not be reported, but instead seek that the IRS issue a prospective-only rule that would (at least potentially) eliminate their members’ liability for having failed to report such interest in past years. We responded with our own submissions here in which we urged that the there is no need for “guidance” since there is a mountain of legal authority that already exists pointing inexorably to the conclusions: (1) that the payment of previously deferred mortgage interest must be reported on Form 1098 by the recipient of that interest in the year of actual payment and (2) that an intervening loan modification does nothing to change this.

We also pointed out that the only reason the ABA and MBA were seeking “guidance” is that some of its members are seeking to have the IRS help them avoid exposure in litigations like ours for their having improperly reported the mortgage interest payments of millions of Americans. Specifically, we stated that they are hoping to be able to create their own precedent so they can argue in Court that the IRS’s issuance of some sort of “prospective” “guidance” proves that an ambiguity existed in the law such that their under-reporting of interest was “reasonable.” However, we argued that the mere fact that some banks are reporting interest in a manner that is contrary to well-established law does not mean that there is an ambiguity in the reporting requirements. It just means that those banks are doing it wrong.

The real truth is that some ABA member banks (like Bank of America) chose expediency over compliance because tracking deferred interest is costly. But accuracy lies at the core of section 6050H. Clearly, any rule that promotes a schism between the amount of interest that a borrower pays to a lender from the amount of interest that lender reports on Form 1098 crosses purposes with the intent of section 6050H (this is not to say that the amount of interest deducted by the taxpayer will always match the amount of interest reported on Form 1098. For instance, a borrower might pay less than $600 in interest and thus not receive a Form 1098, but that borrower could still deduct the interest that he or she did pay). Because taxpayers, their tax preparers, and the IRS all routinely rely on the amounts contained on the lender-issued Form 1098, if pre-existing interest is not reported on Form 1098, most borrowers (and their tax preparers) would never even know: (1) there is a pre-existing interest balance that can be deducted, or (2) how to allocate their mortgage payments to determine in which tax-year they have repaid the prior interest balance. While this may be “good” for the treasury, it is inconsistent with the principle that everyone pays only the amount of tax they are required to pay under the tax code.

These problems all completely disappear if banks simply report the “aggregate” amount of interest (both current and pre-existing) that they actually receive as is mandated by the unambiguous language of § 6050H (recipients of “interest” on “any mortgage” are required to report on Form 1098 (to the IRS and to the payer) the “aggregate” amount of “interest” “received” during the calendar year if that amount “aggregates” to over $600). If that happens, then the taxpayer will deduct the proper amounts and the Form 1098 will have served its raison d’être by helping the IRS to verify that the amounts deducted are proper.

In tomorrow’s post we will discuss the legal issues underlying how banks are supposed to report interest.

Comments

  1. Attorney Vendler, this is a case of borrowers wanting their cake and eat it too. Capitalization of interest for the purpose of refinancing is a long-standing practice in lending.

    When borrowers fall behind on interest payments [generally because they bought more “house” than they could sustainably afford] they can ask their lender — the key word here is “ask” — to have the unpaid interest added to the principal balance as part of a refinance or modification.

    Capitalizing the interest allows borrowers to avoid eventual delinquency and foreclosure by adding to their loan principal balances and stretching the new balances over a longer term to lower their payments. But then, you already know that.

    Is it a wise financial decision? More often than not the answer is no. Whatever poor decisions or other unfortunate circumstances led to the borrower’s current state of affairs, refinancing to roll past debt into a new loan only delays the inevitable. Still, the option to capitalize the interest and avoid delinquency is available to borrowers, and many choose to accept it. They may not like the terms, but they always seem to hope that “things will turn around”.

    The problem we have here is that borrowers want it both ways. They want to brush their mistakes or misfortune under the rug. The ability to refinance to avoid delinquency/foreclosure accomplishes that. But they also want to benefit from deducting all that previously past-due unpaid interest from their tax obligations. In effect, they’re agreeing to the terms of a refinance to “save” their home (the capitalization of interest spelled out in the new mortgage agreement) but only with the underhanded goal of asking Courts to force lenders to not capitalize their previously past due interest.

    Let’s not sugar coat the effort. The costs of a failed/failing mortgage are the terms of a refinance. If we should ever find ourselves in such a situation as borrowers we can either agree to the new terms and keep our homes, for now, or walk away and deal with the consequences. The IRS and fellow American Taxpayers need not subsidize our failures.

    • Jqp speaks as a true bankster (banker-gangster) whose benefit to a free society is doubtful.

      The problem, he claims, is borrowers “want it both ways.” Yet is it not jqp and his fellow banksters who want it both ways? On one hand, the banksters want to rake in every ill-gotten gain after they’ve conned each borrower into signing for their “full house.” On the other hand, when the banksters’ full house gushes water, they want the taxpayers to cover their damages with a wide and a heavy TARP. No, the borrowers’ minor wants are not the problem; the problem is the bankers’ major scams–such as disguising interest as capital.

      In jqp’s bankster-world, borrowers who want to deduct certain paid interest are both eating and having “cake.” Even Marie Antoinette, when told that the masses were rioting because they lacked for bread, at least wondered why the masses did not instead eat cake. If he could, jqp would starve all non-banksters of both bread and “cake.”

      And that just frosts me.

      • Jason,

        There are many issues with your reasoning. I’ll focus only on the first: you assume far too much. I’m neither “bankster” nor “gangster”. I am, however, a former loan officer who encountered thousands of borrowers, many of whom made poor decisions and quickly found themselves in over their heads. A very large majority of them simply didn’t know what they didn’t know. They turned to family, friends and the Internet for poor advice from people who are in no better position to provide it.

        Ultimately, I quit my job because I found my employer to be ineffective as far as pre-emptive consumer education. The organization’s fear of impropriety and potential liability meant I couldn’t help consumers in the manner in which they most needed it. Shortly afterward I founded a 100% volunteer organization to educate consumers about home financing. To-date I have delivered more than 200 free two hour home financing workshops in 6 communities and created more than three dozen free videos on the subject (What have you done to help?). I accept no sponsorshop nor give any referrals. In fact, the towns themselves are allowed to charge for the workshops if they so choose, and keep 100% of the proceeds to cover their facilities costs.

        In my experience, and I suspect I have a great deal more experience than you on this matter, borrowers tend to make poor decisions even in the face of advice and evidence that suggests other courses of action. Too many borrowers live in a fantasy world of assumptions not all that different from your own. They make assumptions about income, promotions, and changes of circumstances that may never materialize. I attempt to help bring them back to reality…to understand how to avoid home purchases and loan terms that might place them and their families at risk. And I provide them with several examples of assumptions gone wrong. My hope is, and continues to be, that they will take my advice seriously. Many do. Unfortunately, some do not and those individuals and families now bear the financial and emotional scars of the borrower’s willful ignorance.

        If you allow yourself to agree to terms that result in you falling behind on interest payments to such a degree that refinancing/restructuring becomes necessary to avoid delinquency/foreclosure, don’t expect the American Taxpayer to bail you out. Especially in the form of tax deductions for the very delinquent interest that necessitated restructuring in order for you to remain in a home that, frankly, you should not have purchased at all. We’re not interested in borrower excuses any more than we’re interested in the excuses of Wall Street executives from failed investment and insurance companies.

        • So “jqp” is really a nice guy–he just wants to deny his clients any tax deductions for their paid, yet now bankster “capitalized,” interest. Despite his moniker, “John Q. Public” he ain’t.

          Anyway, we cannot allow the crux of Mr. Vendler’s post to escape our sight as does “jqp.” His financial services background means he views the banksters’ “interest capitalization” label as controlling the tax deduction question. After all, he reasons, interest capitalization is a long-standing industry practice that shows the masses the price they must pay for their varied financial delusions.

          No, Mr. & Mrs. Borrower with all the houses at sea, ye shall receive not even a widow’s mite, says the financier “jqp.”

          In other words:

          “Billions for capitalization, but not one cent for deduction.”

          • Clearly you contribute absolutely nothing to the conversation. And in the spirit of assumptions I too shall assume you contribute nothing to your local community either.

            Like it or not, you’re in the same league as the worst of the banksters you claim to dislike. Carry on. We won’t hold your hypocrisy against you.

  2. Ronald Wiener says:

    The IRS has established an interesting procedural remedy to deal with the “flip side” of under-reporting interest paid on 1098’s. Sometimes financial institutions mistakenly under-report interest or dividend INCOME on 1099’s they send out to taxpayers. The errors affecting individual taxpayers are usually small, but the aggregate costs of sending out corrected 1099’s can be substantial to the financial institutions, the affected taxpayers [amended returns?], and the IRS [processing myriads of small adjustments]. The IRS, in IRM Part 8, dealing with Appeals procedures, uses Exhibit 8.13.1-12, “Pattern Information Reporting Program (IRP) Closing Agreement for Understatement of Income on Forms 1099 by a Payer (and instructions) for Use on Form 906,” in these situations. The payor/financial institution can enter into a Closing Agreement under which it will pay the estimated tax loss to the Government from the aggregate amount of the under-reported income [e.g., at a 28% assumed marginal tax rate for the payees]. This benefits everyone involved and is a constructive approach to improving tax administration.

    Although I admit I haven’t tried to develop a comparably helpful mechanism that would compensate the adversely affected taxpayers for the overpayment of taxes they made by deducting the interest shown on incorrect 1098’s in the BankAmerica and similar cases, it seems to require a remedy that’s tailored to the individual payees rather than an aggregate approach that by-passes the payees’ need to file refund claims. If a class action on behalf of the payees is successful in a case like the BankAmerica under-reporting of interest expense, I’m curious to know how each payee’s damages will be determined. The Post makes clear the difficulties to be overcome in calculating each payee’s understatement of interest expense, but calculating their tax loss may be even more difficult. I assume that many payees will have used the standard deduction rather than itemized deductions [and therefore would have no damages from tax losses – except for a few for whom the additional deduction might have made it beneficial to itemize] and others would have various tax losses dependent on the differing marginal impacts of the increased interest deductions on their returns – after any applicable PEP, Pease, AMT, and other adjustments. If a settlement methodology could be worked out to the satisfaction of the payors and the class members, maybe the IRS could be brought into the discussions to get a Closing Agreement that would help facilitate the implementation of the proposed settlement. I’m curious about how the plaintiffs propose to handle this.

    Interesting case!

  3. Barry Goldwater says:

    I disagree with Ronald Wiener that this is an “[i]nteresting case”. In fact, I wasted serious toilet time reading this post. No, Ronald, there is nothing interesting about the failings of an artificial system that burdens every single person and business in which it comes into contact. Page 99 of the 2016 Form 1040 Instructions says that it takes 13 hours for an individual to complete and file a tax return. I doubt the time wasted on this litigation is part of the 13 hours.

    When we file our tax returns on postcards as some POTUS candidates are advocating, the bright people at banks, the IRS, law firms and law schools can find better ways to spend their time and money. THAT will be interesting.

    • When the government first issued it, the income tax return was short and simple. But then the POTUS candidates, the bright people at banks, the tax collectors, the law firms, and the law schools chose to spend their time and money in better ways.

      Interesting, huh?

  4. Deborah Percell says:

    The post for tomorrow’s on the underlying legal issues on how banks are suppose to report interest will perhaps address the jqp comment on capitalization of interest for refinancing purposes. Apparently if the borrower is entitled to the interest deduction and it should be reported on their Form 1098 should not the lender be including the interest as income at the time of the loan modification as well? Just a thought.

  5. Well, I had no idea of the political nature of the comments I would get. Anyway, as Ms. Percell correctly predicts, my second post indeed does talk about how interest does not lose its character as interest simply by being capitalized. Indeed, the Tax Court in the Copeland case cited therein specifically holds that such interest is deductible upon repayment. Thus, with respect to jqp’s post, there is no “cake and eat it too” problem. Nor is whether a consumer’s entering into a modification is a sound financial decision relevant to the issue. The issue is simply whether the interest that is collected by the banks should be reported on Form 1098.

    • First, Attorney Vendler, thank you for your follow up post and additional context.

      There is most certainly a “have one’s cake and eat it too” mentality in the sense that current legislation and legal rulings support a method of circumventing the terms of financial agreements…effectively legalizing poor behavior.

      What disincentive exists to motivate borrowers to adhere to loan terms when they can fall behind on interest payments to the brink of foreclosure, apply for restructuring, and begin the cycle all over again with impunity? Certainly not the inability to deduct previously past due interest. Where is the lesson to be learned?

      Modification of an already failed and now high risk loan isn’t sound financial decision-making. It’s an act of desperation. In business, we refer to it as a band-aid solution. While this uncomfortable fact may not be relevant to your case, it is relevant to the long-term financial well-being of the borrower.

      Thank you again for the additional information in the follow-on post.

      • So “jqp” despises laws and rulings that “support a method of circumventing the terms of financial agreements” and thus “effectively legal[ize] poor behavior.”

        I presume his despising extends to the U.S. Constitution. As we discussed last week, that instrument vests in Congress the power to make uniform bankruptcy laws.

        If he believes one’s loan modification application is “an act of desperation,” what must “jqp” think of one’s bankruptcy petition?

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