Living With Your Decisions: Delinquent Mortgage Debt

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While not so much a procedure case, last month’s case of Copeland v Commissioner caught my interest, and does bring up a procedural issue in a way. It involves the deductibility of qualified residence interest. In Villanova’s graduate tax program and in law school, I have struggled (along with my students) with some of the cases that have disallowed deductions when individual taxpayers have borrowed additional money to pay back interest on a delinquent loan.  Courts and IRS put the kibosh on deductions when the new loan comes from the same lender as the old delinquent loan; the theory in those cases is that the taxpayer has not really gone out of pocket and that there is just a shuffling of papers.

On the other hand, if a taxpayer gets a new loan from an unrelated party, and uses those borrowed funds, the courts and the IRS have generally allowed the deduction. Economically, there is not much difference (after all the borrower may just as well not pay back the new lender), but form matters, at least some of the time. That takes us to the Copelands, and how sometimes the form chosen may produce an unfortunate tax outcome.

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First, some facts:

Petitioners are cash basis taxpayers. In 1991 they purchased a residential property in Yucaipa, California, for $334,000. They financed this purchase with a $300,000 mortgage loan secured by the property. Petitioners have occupied this property as their home since 1991. In 2007 petitioners refinanced the Yucaipa property with a $600,000 loan from Gateway Funding Diversified Mortgage Services (GFDMS). This loan was likewise secured by a mortgage on the property. Bank of America subsequently acquired the GFDMS mortgage loan.

Like many other taxpayers in the great recession the Copelands had a hard time making ends meet and were behind with their creditors, including Bank of America. In 2010, they sought a modification from Bank of America:

This [modification] application was granted, and the terms of petitioners’ mortgage loan were permanently modified. The modifications included a reduction of the interest rate, a change in the payment terms, and an increase in the loan balance. Immediately before the modifications, the outstanding loan balance was $579,275; after the modifications, the new balance was $623,953. The difference (equal to $44,678) resulted from adding the following amounts to the loan balance: past due interest of $30,273, servicing expense of $180, and charges for taxes and insurance of $14,225.

In 2010, the Copelands sought to deduct the delinquent interest of $30,273 that became part of their new balance following the modification. IRS disallowed the deduction, and Copelands petitioned the case to Tax Court.

As Copeland discusses, cash basis taxpayers are generally not allowed a deduction, whether it is for interest or other items, when they make a mere promise to pay an obligation. Deductibility generally comes in the form of a cash transfer or a transfer of a cash equivalent.  When it comes to delinquent interest, (mostly post-86 Tax Reform Act in the form of qualified residence interest as other consumer interest is generally not deductible), a taxpayer facing back due mortgage interest cannot get a deduction when he executes a new note to the lender adding to the balance that is owed by the delinquent interest. The reason, as Copeland discusses, is that “the note may never be paid, and if it is not paid, the taxpayer has parted with nothing more than his promise to pay.”  (internal citations omitted)

Here, facing a modification of an existing debt, the Copeland court agreed with the IRS’s disallowance essentially due to the rationale discussed above:

Through the loan modification agreement, the $30,273 in past-due interest on petitioners’ mortgage loan was added to the principal. No money changed hands; petitioners simply promised to pay the past-due interest, along with the rest of the principal, at a later date. Because petitioners did not pay this interest during 2010 in cash or its equivalent, they cannot claim a deduction for it for 2010. They will be entitled to a deduction if and when they actually discharge this portion of their loan obligation in a future year.

All this takes us to the procedural issue the taxpayer raised. Essentially, the taxpayers argued that they could have borrowed money from a new lender, and if they in fact used newly borrowed funds to pay delinquent interest, they would have been allowed the deduction.

[P]etitioners ask us to recharacterize their loan modification transaction. Instead of having modified the terms of their existing loan, petitioners say they should be treated as if they had obtained a new loan from a different lender and used the proceeds of that loan to pay both the principal of the Bank of America loan and the past-due interest.

The court did not accept the taxpayers’ argument. In addition to noting that its actual transaction was not the same as a new loan (and taking issue with whether they “could have obtained a $623,952 loan from a different lender, given the economic environment prevailing in 2010”), the killer for the Copelands was that they made their bed and had to lie in it:

In any event, it is well established that taxpayers must accept the tax consequences of the transaction in which they actually engaged, even if alternative arrangements might have provided more desirable tax results.

To that end, Copeland cites a 1977 Supreme Court case, Williams v Commissioner, which (citing to older Supreme Court cases) emphasized that a “taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not . . . and may not enjoy the benefit of some other route he might have chosen to follow, but did not.”

Conclusion

Copeland reminds us that once a taxpayer chooses a transaction, it is likely not going to succeed by showing how an economically equivalent transaction may result in a more favorable tax outcome. By choosing the wrong process the taxpayers got a result they did not want substantively.  Similar results can come when you choose the wrong procedure and argue that you should get a benefit that would have been available had you chosen another procedure.  Voluntary payment comes to mind.  If a taxpayer makes a payment and does not designate then the IRS will put the money where it wants even though had the taxpayer chosen to use the procedure of designation, he would have been able to put the money on another tax debt. Somewhat similarly though with much bigger numbers at stake, I discussed last month’s Ford decision where Ford made the choice of not designating a remittance as a payment and thus lost on its suit for additional overpayment interest.

 

 

 

 

Leslie Book About Leslie Book

Professor Book is a Professor of Law at the Villanova University Charles Widger School of Law.

Comments

  1. If the new loan is with the same lender, the Taxpayer would be allowed a deduction if the Penalty is paid and not rolled into the new loan {U.S. Bancorp v. Commissioner, 111 T.C. 231 (1998), a lessee was required to capitalize a lease cancellation payment made in order to enter into a more favorable lease with the same lessor.}. Additionally, the Penalty is not acquisition debt (A, C, I). They are home equity debt and are subject to the interest on $100K limit and all other limits on home equity debt.

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