Update on Issues Relating to Financial Institutions Underreporting Mortgage Interest to Millions of Consumers

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One of the most viewed posts on Procedurally Taxing in the last year or so 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. Earlier this year the lead attorney on that lawsuit, David Vendler of Morris Polich & Purdy, wrote a two-part post An Update on the Lawsuit Against Bank of America for Failing to Issue Accurate Interest Information Statements. When we last heard about the issue the IRS was seeking input through the Industry Issue Resolution program. Today David tells us that that the IRS has terminated that IIR project and added it to its list of guidance priorities for 2016-17. The issue is one with major implications for millions of consumers. The bankers are obviously well-represented in the guidance process. As David discusses there is a strong need for IRS and Treasury to hear how financial institutions should be required to report the payment of interest payments following loan modifications and other transactions like short sales when consumers are effectively paying substantial amounts of interest but not receiving information from banks that would allow them to determine whether the interest is deductible. Les

To all of you tax professionals reading this, I need your help.  Some of you may recall my two-part post regarding whether 26 U.S.C. section 6050H requires lenders and mortgage servicing entities to report payments of “capitalized” mortgage interest they receive from borrowers on IRS Form 1098 so that the borrowers can then deduct those payments.  The issue literally involves billions and billions of dollars in mortgage interest deductions that millions of American homeowners are losing because of the failure of their mortgage servicers to properly report.  As described in my prior posts, the situation arises in the contexts of negative amortization/Option Arm loans as well as loan modifications.  It also, however, arises with short sales, which was not discussed in my prior posts.  (Basically, if you look at the 1099-C that the consumer receives following a short sale, you will note that box 2 (which requires the reporter to indicate how much of the debt being cancelled is mortgage interest) is generally left blank.  This means that all of the cancelled debt is principal.  This is correct since mortgage notes generally require allocation of payments to interest before principal.  But in the short sale context, while the banks and mortgage servicers are correctly reporting the amounts of debt being cancelled, they are not reporting the other side of the transaction on Form 1098, which is the amount of interest being paid from the sales proceeds.  This amount can be in the tens of thousands of dollars)

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Anyway, following my bringing lawsuits against certain banks arising from their failure to properly report their customers’ interest payments, the American Bankers Association and the Mortgage Bankers Association requested the IRS to address the issue.

In late December 2016 the IRS responded that it would address the issue via its Industry Issue Resolution (“IIR”) program.  This program, however, does not provide for public comment and I was afraid that the banks and the IRS would simply arrive at “guidance” that would conclude that section 6050H was ambiguous as to whether it required payments of capitalized interest to be reported.  This way, even if the IRS concluded that I was correct about the reportability of the interest, the banks could then use the “guidance” announcing that there was an ambiguity to “prove” that they did nothing wrong in not previously reporting  payments of capitalized interest.

In fact, however, there really is no ambiguity.  The law is very clear and can be stated in a single paragraph.  21 U.S.C. section 6050H unambiguously requires banks and mortgage servicers to report on Form 1098 the “aggregate” of all mortgage interest they receive in a year (if that amount is over $600).  The Supreme Court has held that “interest” unambiguously refers to money that has been charged for the use of money.  Deputy v. DuPont, 308 U.S. 488 (1940).  Case law further uniformly holds that payments of capitalized mortgage interest (whether in the loan modification context or the negative amortization loan context) are payments of mortgage interest that can be deducted in the year of payment.  See Copeland v. C.I.R., T.C. Memo. 2014-226, (capitalized pre-loan modification interest held deductible as mortgage interest in the year of payment); Smoker v. C.I.R., 2013 WL 645265 *6 (Tax Ct. 2013) (same holding in the negative amortization loan context) [note Les discussed Copeland on PT  here].  Since capitalization of interest does not change its character as interest (Motel Corporation v. Commissioner of Internal Revenue, 54 T.C. 1433, 1440 (1970)), payments of capitalized mortgage interest are part of the “aggregate” mortgage interest that banks and mortgage servicers “receive” and thus are required to be reported on Form 1098 by the plain and unambiguous language of section 6050H.  Indeed, it was for this very same reason why 26 CFR § 1.6050S-3(b)(1) specifically requires that payments of capitalized student loan interest be reported on Form 1098-S.  There is simply no logical distinction that can be made between the reportability of payments of capitalized student loan interest and capitalized mortgage interest.

After a bunch of submissions on my part to the IRS requesting to be included in the IIR process, the IRS has just last week declared that it is terminating the IIR process and will address the issue of the reportability of capitalized interest on Form 1098 by formal rulemaking.  I see this as very good news insofar as the public, including you, will have an opportunity to comment.  I further fully expect that whatever rule the IRS eventually publishes will be consistent with all of the law above since this was the conclusion the IRS reached on the reportability of student loan interest way back in 2004.  That said, I expect that there will be heavy pressure from the banks and mortgage servicing entities to push for a rule that is “prospective-only” as was done with the student loan interest rule back in 2004.  This will hurt consumers tremendously.  Banks should instead be required to issue corrected Forms 1098 to all consumers which will (retrospectively) inform them of the interest that was not reported to them and allow them to file an amended return (if the statute of limitations has not expired) to recover his/her deduction.  Further, if consumers are really to be helped, the IRS should include in its rule an exception to the statute of limitations (based on the fact that because of the bank’s misreporting, the consumer was unaware of the potential for amendment previously), or allow consumers to take the prior deductions in the current tax year.    There simply is no justification for a prospective-only rule precisely because the question of the reportability of payments of capitalized interest has already answered.  The mortgage industry just ignored that answer for the sake of reporting convenience.

So, what I would like from anyone who feels equipped to do so is to write to the IRS (prior to the official public comment period which comes after a proposed rule is formally announced) and let them know your thoughts.   Comments can be sent directly to Thomas.West@treasury.gov prior to the formal public comment period.  Further, if any of you have any questions, please address them to me at dvendler@mpplaw.com

Comments

  1. David Vendler says:

    This is David.

    I wanted to share some correspondence I received today and my response with all of you. The exchange is below without the author’s name.

    Dear Mr. Vendler,

    I read your blog post in procedurallytaxing.com

    Your argument makes some sense when there is a loan modification with the same mortgage lender, and the original loan was not assigned prior to modification. In all other cases, the lender on the modified or subsequent loan will not have the information required to determine the amount of capitalized interest.

    There is a similar issue with refinancing costs and points on refinanced loans. Points on an original home purchase loan can be expensed as interest (although there is no requirement that this occur). Points on a refinancing, and points on a home-equity loan or HELOC, must be amortized over the remaining loan term. And when a subsequent (second or third or fourth) refinancing occurs, unamortized points from the prior refinancing(s) must continue to be amortized. Banks certainly have not retained the information necessary, and in many (my guess is in the majority of) cases never had, the information necessary to report the information that borrowers need.

    This reminds me of the broker reporting rules for Forms 1099-B. Even with prospective rules, the IRS delayed implementation for several years, because it was so difficult for brokers to implement a system to track basis when assets were transferred from another broker. Capitalized interest is, in a way, worse, because, unlike basis, it can easily be affected by borrower elections, borrower misreporting, and non-lender expenses.

    There is a lot that can be done to improve reporting for interest payments. But I don’t think it is as simple as your post suggests. I may take up your suggestion to write the IRS, but my comments will probably look a lot like this email.

    Given the incoming Administration’s stated intent to repeal Dodd-Frank (which substantially tightened borrower protection), I think the likelihood of any new regulation is slipping. If you can get prospective-only regulation, take it.

    Here is my response.

    Joe

    Thanks for your comments. Let me first say that I agree with you on your basic premise that there are a lot of issues with interest reporting that really do need to be addressed. However, by my understanding at least, the only issues the IRS is taking up are the two which were initially taken up by the Service via its IIR program, and which it has (apparently) decided to resolve by rulemaking. Those issues, as stated by the Service are:

    •The first submitted by the Mortgage Bankers Association on reporting requirements under IRC 6050H following a significant modification of a mortgage where the principal amount of the modified mortgage exceeds the principal amount of the pre-modified mortgage.

    •The second submitted by the American Bankers Association on reporting required on a mortgage where accrued but unpaid interest is added to the principal.

    As I read your chief concern with my blog post, it is that a bank which takes over a loan from another bank will not have the necessary background information to properly report the borrower’s full interest payments. I have two general responses to this and then I will “get into the weeds.” First, I think that in both of the narrow situations above, the lenders do have all of the necessary information to properly report. Second, and more practically, consumers certainly don’t have the ability (even if they have the necessary information) to properly calculate their interest payments and the unambiguous language of section 6050H puts the onus of calculation squarely on the recipient of the interest. And that is my chief goal – to get consumers the information they need to get the deductions they are entitled to, and not just for the future, but also the past.

    I don’t think from your email that you disagree with me that as to the deferred interest on negative amortization/Option Arm loans, even lenders who take over loans after origination do in fact have all of the information they need to properly report the consumer’s payments of previously deferred interest. All that is needed in the Option/Arm situation to calculate payments of previously deferred (capitalized) interest is the original loan amount, the payment history for the time that the bank has had the loan, and the current loan balance. This is true even if a lender has taken over a loan mid-year since payments are allocated to interest prior to principal. Indeed, I have settled cases where lenders who have taken over stub-years have managed to issue corrected 1098’s reflecting the customer’s “true” interest payments based on the information described above. (I understand that pre-paid points are a different animal entirely in terms of a lender arriving late on the scene. But, at least as I understand it, those are not part of the IRS’s current analysis). Indeed, I don’t think that there has ever been any serious disagreement that payments of negative amortization interest in the Option Arm context should be reported on Form 1098; none of the banks I have sued has even advanced such an argument. The most they could muster was to say that there is no guidance on the issue from the IRS. But this, to my mind anyway is an incomplete argument without taking the second step (which none have) which is to argue that existing law is in any way inconsistent with my position. In short, the banks are trying to create an ambiguity where there really is none. By saying that there is “no guidance”, they want to imply that two interpretations are possible. But my point is that there is no need to issue guidance when only one conclusion is reasonable from the law. The IRS answered the question of whether capitalized interest should be reported in the student loan context back in 2004. By failing to offer any legal support for an alternative reading of section 6050H, i.e. one where such interest would not be part of the “aggregate” of all interest they are receiving, the supposed ambiguity they want to imply breaks down. Indeed, precisely for the reason that there is no reasonable way to construe the law to reach the conclusion that such interest is not reportable, many lenders have always reported payments of negative amortization interest properly (Well Fargo and Chase for instance do so). Personally, I think that the failure of other banks to do so (like Bank of America) is through negligence rather than by design; they simply that they did not think about the issue when they programmed their computer system for tracking interest payments. Thus, once I brought the matter to Bank of America’s attention, for instance, it quickly settled and retroactively reported those payments to the tune of over $2 billion dollars. If it had thought I was wrong, it certainly would not have done so since the IRS has the power to penalize banks very heavily for wrongful informational reporting. For all of these reasons, I don’t think (at least as to the negative amortization/Option Arm loan issue), that the banks deserve a prospective-only ruling. There simply was no ambiguity in the law that would justify giving them such a break.

    As for loan modifications, I agree with you that the situation is a bit more complex. I also think from your email saying that I make “some sense” that you agree that pre-modification interest retains its character as interest which can be properly deducted upon payment post-modification. I am not sure that the IRS will agree with this basic point so I would appreciate your support on that issue if nothing else. Assuming that we do in fact agree on this point, then such interest is necessarily part of the “aggregate” of mortgage interest that banks receive and thus falls generally within the definitional language of section 6050H. Where we seem to disagree is on your point regarding loans that change from one bank to another. I am certainly no expert in bank purchases of loans, however, I do think that acquiring banks who then subsequently enter into modifications of those loans with their borrowers do have all of the information necessary to be able to properly track and report all of the pre-modification interest that is paid by the borrower post modification. After all, the acquiring bank will know upon acquiring the loan both the original amount of the loan and the current loan balance, including the outstanding interest and all penalties. Assuming that the bank then grants a modification which wraps the entire loan balance (including outstanding interest, penalties and the original principal) into a single “new principal balance”, the bank will know exactly how much of the “new principal balance” was interest and can thus track the borrower’s payment of that interest (as well as current post-modification interest) pursuant to the allocation terms of the note. I want to stress that I agree with you that this argument does not apply to new loans entered into by a bank which takes over from another lender. In that case, the old loan is paid off and the new lender starts fresh. But in the true loan modification context, the modification agreement is very clear that it is a modification and not a new loan. The balances are thus fully known. The same note continues in effect and all of its provisions retain life after the modification except for the ones explicitly modified (including the allocation provisions). Again, it is my position, and I hope you will join me, that in the situation of a true modification, the plain language of section 6050H governs and that whatever rule the IRS issues will be one that not only declares that the onus of reporting should fall on the banks, and that since there was never any legal ambiguity on the point of whether pre-modification interest continues to be interest after the modification, the banks should not get a prospective only rule.

    Ultimately, I think that our “disagreement”, if there is one, comes down to the scope of our analysis. I am limiting mine to the two narrow questions that the IRS has told me it is considering. On those narrow questions, I think that we might even agree. When the focus is expanded to include such things as points and interest that exists that then gets wrapped into a genuinely new loan, I also think we might come to the same conclusions. But what I am asking from interested parties like you is to focus on the narrow issues at hand.

    Finally, as to your point regarding the new administration, yes, I agree with you that we may never see a regulation issue. And if that happens there will be nothing I can do except continue my own private enforcement efforts through my lawsuits. But I am hopeful that the IRS will step in since I see the law as very clear and the consequences to consumers as very severe. I further don’t think that the banks deserve a break in this instance since I believe the law is so clear. I am not advocating that banks be punished for issuing wrongful returns. Rather, I am simply asking for a rule that requires correction of past years. A prospective only rule will not do that and consumers will thus lose the ability to deduct billions in interest payments they indisputably made. In short, consumers can “win” this battle with very little cost to the banks.

    OK, I have now said my full piece. No matter what you decide to do vis à vis the IRS, I want to thank you for your considered thoughts on my post in Procedurally Taxing. If you want to respond to this email, you will find and interested reader. But if not, thanks again.

    Yours,

    David Vendler

  2. To help clarify this concept, I’d love to see a simple example of exactly how interest was reported incorrectly — with at least this information:

    Original loan terms: (principal, rate & term);
    As of last timely payment date: principal owed and YTD interest paid;
    Missed or short payments, if any with unpaid interest stated;
    Modification terms with amount of unpaid interest deferred, if any;
    Clarification of capitalized interest; and,
    Any other meaningful data.

    • David Vendler says:

      Dallas:

      Let me first take you through the loan modification issue. Assume that as of January 1, 2012, John Doe has a mortgage loan with BANA on which he owes $600,000 in principal and that his monthly interest obligation is 10% per anum, or $5,000 per month.
      During 2013, Mr. Doe experiences financial difficulty, falls behind on 4 months of payments ($20,000 worth of interest), and requests a loan modification from his lender. Because of the processing time between Mr. Doe’s application and the grant of his loan modification, another 8 months pass without any further payment by Mr. Doe ($40,000 in interest). Thus, as of January 1, 2013, the effective date of Mr. Doe’s loan modification, his loan balance consists of $600,000 in original principal and $60,000 in unpaid interest.
      Under the terms of the modified loan, Mr. Doe is provided a reduced interest rate of 3% per year. However, per the loan modification agreement, interest will not only be charged on the original $600,000 principal, but also on the $60,000 in previously deferred interest. Further, the loan modification agreement provides that the loan will be reamortized to be repaid in full (principal and interest) over a new 30-year period beginning on the date the modification becomes effective. This means that Mr. Doe’s new monthly payment includes two components; (1) $1,650 in interest for the month in which the payment is made (“current interest”) and (2) an additional sum sufficient to result in the repayment of the modified loan balance amortized over the new 30-year term. For the purposes of this example, assume that that this amount averages $350 per month for all of 2013. Thus, Mr. Doe’s total payments for 2013 will total $24,000. Under many banks’ current (and wrongful) Form 1098 reporting policy, they will report only Mr. Doe’s $19,200 payment of current interest on Mr. Doe’s Form 1098. As to the additional $4,200 Mr. Doe paid in 2013 toward reducing the $670,000 post-modification loan balance, these banks count the entire amount as a repayment of “principal” and do not report any of it on Form 1098. While certainly simple and straightforward, this does not make the calculation correct since it fails to take into account that $60,000 of Mr. Doe’s $660,000 post-modification loan balance is itself interest, i.e. money that was charged Mr. Doe for the use of the original principal.

      In terms of negative amortization loans, I provide the following example from one of my complaints
      10. Plaintiff owns a single family home located at 5049 Midas Ave., Rocklin, California which was at all times relevant hereto, her primary residence. On or about November 10, 2005, Plaintiff obtained a negative amortization loan in the principal amount of $524,000 from [Lender “A”].
      11. Her note provided Plaintiff with a “Minimum Payment” which resulted in negative amortization during the loan’s pendency, such that when [Lender “B”] took over servicing her note in December of 2011, Plaintiff’s loan-balance was $533,013.02, or $9,013.02 above the original principal amount of the loan. The entirety of this $9,013.02 is unpaid interest, since it was charged to Plaintiff for her use of the original principal. This interest was incurred, but not paid, by the Plaintiff in earlier years of her loan.
      12. Since Lender “B” took over servicing Plaintiff’s loan in December 2011, Plaintiff has made all of her payments required under her note to Lender “B”. During tax year 2011, Plaintiff’s payments to Lender “B” totaled $2,698.20.
      13. In or about February 2012, Plaintiff received a Form 1098 from Lender “B” supposedly reflecting the amount of mortgage interest that it had received from Plaintiff during tax-year 2011. Although Plaintiff had paid $2,698.20 to Lender “B” on her note during 2011, the Form 1098 she received reflected only $1,443.58 in mortgage interest paid. This is the amount of interest accrued and paid on the 2011 balance owed. The Form 1098 for tax-year 2011 also reflected that Plaintiff had paid $1,254.62 in supposed “principal.”
      14. Lender “B’s” method for calculating mortgage interest is wrong because it assumes that the entire loan balance that it took over in December 2011 was comprised of principal, and fails to recognize that the interest that was previously deferred does not lose its character as interest simply because it is paid back at a later time, or to a different mortgage servicer. Because Plaintiff still owed previously deferred interest on her note as of the date that Lender “B” took over her loan, Lender “B” should have credited all of Plaintiff’s payment toward retiring Plaintiff’ deferred interest balance before crediting any of her payments to principal.

      I hope these examples help you to understand the problem.

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