The following is the first part of a two-part post addressing lawsuits relating to allegedly erroneous information returns Bank of America issued; today’s post relates to the issuance of Form 1098 (mortgage interest) and tomorrow’s relates to 1099C (cancellation of debt income). An earlier version of the posts appeared on the Forbes PT site on January 6, 2015.
A couple of developments from late last year involving Bank of America and its issuance of supposedly erroneous information returns are worth highlighting. One relates to Bank of America’s mortgage interest reporting on Form 1098 and the other relates to its issuance of Form 1099C addressing cancellation of debt. Both cases implicate federal and state law causes of action to remedy what the plaintiffs allege to be fraudulent or at a minimum negligent conduct by Bank of America. The plaintiffs in both cases elicit sympathy and as we move into the information return issuance season, the cases should give even greater incentive to take care in issuing tax forms that may provide a pathway to unanticipated liability.
In today’s post, I will discuss the case of Smith et al. v Bank of America, which addresses supposedly incorrect 1098s that, according to the complaint, stemmed from Bank of America intentionally and systematically understating millions of dollars in homeowners’ mortgage interest payments. Tomorrow I will talk about the case of Raley v Bank of America, where Freddie Raley, a disabled veteran, sued Bank of America after receiving what he claimed to be an incorrect Form 1099C showing cancellation of debt income stemming from credit card accounts he claimed to have not opened. Both cases feature plaintiffs’ use of state law causes of action to attempt to hold the financial giant liable for its actions and highlight the limitations of Section 7434, which allows private parties to sue issuers of certain fraudulently issued information returns.
read more...Smith et al. v Bank of America
First, I want to focus on the 1098 mortgage issue and the case of Smith et al. v Bank of America (BOA) from the Central District of California. (Case Number 2:14-cv-06668-DSF-PLA). Last week, Reuters reported that plaintiffs have been seeking class certification relating to the bank’s alleged underreporting of mortgage interest.
The facts in the case are reminiscent of the Copeland v Commissioner Tax Court case I wrote about late last year in Living With Your Decisions: Delinquent Mortgage Debt. The BOA lawsuit essentially involves homeowners who fell behind on mortgages (both principal and interest) and then received a modified loan from BOA for the delinquent interest balance plus the principal. The modified loan often changed key aspects of the original debt, including the length of the loan and interest rate.
A simplified example taken from the BOA complaint may help illustrate. Assume a homeowner facing financial distress has a $600,000 principal balance on a 15 year mortgage issued by BOA. At the time of the modification, the homeowner may also owe $60,000 in delinquent interest. After the modification, the homeowner has a 30 year mortgage and owes BOA $660,000. That amount consists of the original principal plus the $60,000 in back interest.
In Copeland v Commissioner, using this example, the taxpayer sought to get the $60,000 deduction at the time of the modification. As I discussed in my post, the IRS properly disallowed the interest deduction for the back due interest in the year of the modification. As the court explained,
[t]hrough the loan modification agreement, the…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.
Unlike Copeland, the homeowners in Smith did not deduct the delinquent interest at the time of the modification. The BOA lawsuit thus is about the payment of the past due interest in the future years, and BOA’s failure to include that amount in subsequent Form 1098s to its borrowers. When the taxpayer subsequently pays the amount of back due interest over the period of the modified loan, that amount should (plus the interest paid on the modified $660,000 debt) give rise to a deduction under Section 163 in each year of payment.
In the BOA case, the bank failed to report on the Form 1098 the amounts that were in respect of the delinquent interest that was rolled into the modified loan. The following summary of the facts is from the bank’s memorandum in support of its motion to dismiss the complaint:
Plaintiffs Lora Smith and Cynthia Himple borrowed money from predecessors of Defendant Bank of America, N.A. (“BANA”) to buy their homes. After Plaintiffs fell behind in their loan payments, BANA – rather than foreclose on their homes – agreed to modify their loans. When it did so, any accrued interest that Plaintiffs had not paid or had contractually deferred paying was added to their modified loans’ principal balances.
In subsequent years, Plaintiffs made payments on their modified loans that reduced their loans’ principal balances. Plaintiffs allege that these payments were interest payments, asserting that the payments reduced the portion of their loan principal balances attributable to the previously unpaid or deferred interest. Plaintiffs therefore allege that, under 26 U.S.C. § 6050H, BANA should have reported those payments as “interest received” on Internal Revenue Service (“IRS”) Form 1098 (Mortgage Interest Statement). Form 1098 is an IRS information return, which BANA files with the IRS to assist the IRS with checking the accuracy of claimed mortgage interest deductions. Because BANA did not report those payments on Form 1098, Plaintiffs suggest that they claimed a smaller mortgage interest deduction than they should have claimed, thereby overpaying their taxes.
In other words, in later years the bank only reported on 1098 the amount of interest paid on the modified loan, rather than that amount plus any portion of the payments on the modified loan that satisfied the deferred interest rolled into the modified loan. Those actions, according to the complaint meant that Bank of America was “systematically, knowingly and intentionally underreporting on Forms 1098 hundreds of millions if not billions” in interest.
The original complaint raises state law claims of breach of contract, fraud, breach of implied covenant and a violation of California’s Unfair Business Practice Act. It also seeks a judgment ordering the court to correct BOA’s reporting practice prospectively. The complaint also alleges that the bank a violated Section 6050H (requiring the reporting of interest over $600 paid on a mortgage).
The complaint also alleges that BOA knew that its practice was wrong but that it did so to minimize its reporting of income (interest is income, principal is not) and to minimize its compliance costs in issuing the Form 1098s. For good measure, the complaint alleges that the bank “actively concealed” its reporting policy from its borrowers and that its actions caused “tens of thousands of taxpayers to unknowingly file erroneous tax returns which will have to be unwound at substantial cost” and that some of the homeowners will be precluded from getting relief from the IRS due to the passing of the statute of limitations on refund claims.
In response, in addition to disputing the class certification, on the merits the bank argues that the homeowners were free to report on the 1040s the correct amount of interest irrespective of the amount that the bank reported on the 1098. Moreover, the bank argues that Section 6050H of and the regulations under the statute did not require the bank to report the amount of interest attributable to the defaulted or deferred interest from the original loan. In addition, the bank argues that Section 7434 of the Internal Revenue Code, which does provide a federal cause of action for fraudulent information returns, does not include the Form 1098 for mortgage interest and that a violation of Section 6050H does not provide the basis for awarding damages to the homeowners.
I am sympathetic to the bank in its view that conduct that may run afoul of IRC Section 6050H does not trigger a private party’s cause of action and it is clear that Congress failed to include a 1098 as a type of return that can generate a private party’s suit against an issuer. On the other hand, BOA was wrong even if it is not actionable under 7434. The bank has a responsibility to get this right and it is unfair that the bank did not provide the requisite information for homeowners to readily compute the amount of interest that should be deductible. Homeowners, especially those going through traumatic financial times, should be able to rely on a Form 1098 they receive from a bank as a presumptively accurate statement of their deductible home mortgage interest.
In addition to the problems it creates for homeowners, BOA’s actions triggered problems for the IRS, which now must dedicate resources to address homeowners who may have questions or file amended returns to claim the proper amount of interest. BOA is the party with the information and resources to report the interest, and its actions have disadvantaged the homeowners and the IRS.
From a tax procedure and administration standpoint, the simple fix going forward is to clarify that banks are required to report under Section 6050H the total amount of interest paid, inclusive of past due interest amounts that are rolled over in a modified mortgage. That would provide an incentive for banks to get this right, as there are penalties the IRS can impose for failing to issue proper information returns. Moreover, perhaps Congress should amend Section 7434 to include Form 1098 as part of the covered information returns that can trigger a private party’s lawsuit against an issuer of the wrong information return. (I also question whether fraud alone should be required to tag an issuer with liability under 7434, and I address that briefly tomorrow, in my post on the case of Raley v BOA).
As a remedy in this case, apart from what Ms. Smith seeks, taxpayers could, subject to the statute of limitations on refund claims, go back and properly deduct the interest that they paid on the modified loans. Yet, it does seem possible that the court will find that remedy insufficient, and the class action aspect of the case is significant for many taxpayers (and plaintiffs’ lawyers). We will keep an eye on this case.
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I thought B of A had argued that the interest not paid is capitalized and added to principal.
The bank seems to be arguing that based on a revenue ruling and the lack of precision in the 6050H rules it is incumbent on the homeowners themselves to compute the proper amount of interest deduction, even if the payments on the modified loan reflect in part some capitalized interest. From the bank’s motion to dismiss the complaint (at around pages 9-11):
I need talk to someone about BOA. IRS contacted us staing we did not file $7000. BOA reported to the IRS we paid them additional $7000 on top of the $4000 we paid in Taxes. They claim we gave them the money to go towards the interest. Who would do that! BOA is giving us the run around. No one can tell us how this happened.
An interest recipient who contractually labels interest as principal does not thereby make it so. Bank of America could modify the loan terms; it could not modify their tax consequences. Simply put, mere labels do not control.
Also, if all homeowners are themselves obliged to determine their mortgage interest payment, then the Form 1098 filing requirement is both superfluous and, as BOA has shown here, meaningless.
Your article has struck another chord with me in my practice. I have on at least two occasions this past year alone seen two clients with modified mortgages that wound up ultimately in foreclosure. (It turned out that the modification was only in the big picture delaying the inevitable, although it certainly wasn’t the debtor’s intention.)
Now, since paying off the capitalized interest portion of the modified mortgage would have resulted in deductible interest (either as Schedule A or as Schedule E), then under 108(e)(2), that portion of canceled indebtedness that would have given rise to a deduction had it been paid does not give rise to income.
I now realize I have two amended returns to file for last year as I have missed this point. I have two clients that are going to be quite happy about this news. Darn this stuff is tricky.
What a great point Charles. Thanks for sharing.
I’m sorry. One more share…how many tax professionals realize that every mortgage modification has a “balloon” of capitalized interest sitting in it. Thus, when that property is sold or refinanced, the taxpayer should receive a huge mortgage interest write off. And by the way, forget Bank of America, this ain’t happening anywhere folks. I haven’t seen this happen once, and each tax accountant with more than a few hundred tax clients must have half a dozen mortgage mods amongst our population of clients.
We are all missing this.
BoA is telling me I am not getting a 1098 for 2014, so I started doing some research. I am very confused. My home loan was modified after much fighting, they said I claimed too much interest in the 2 previous years (what? I used the 1098 that they gave me). So where did all the money go that I paid? It certainly didn’t go to the principle.
Thanks, both of you, for the clarification and great points!
This was not caused only by mortgage modifications. I mentioned this story to my client who received corrected 1098 forms from BofA last March — for 2010, 2011 and 2012 — and did not receive the 2013 form until well past the January deadline.
He explained to me that with the mortgage in question, he had the option with each payment to pay some of the interest; interest only; interest and principal based on a 50-year amortization; or interest and principal on a 30-year amortization. This was a choice available for each payment, not cast in stone at origination. He deferred interest for a while, then started paying it. The property is a rental.
I have read that Fannie Mae, Freddie Mac, and US Treasury have all issued formal updates requiring the exclusion of capitalized interest from box 1 of IRS form 1098 for lenders who participate in HAMP.
Is that possibly correct?
Citations?
We started modification with B of A in 2008 when my husband lost his job. After many times of returning their packets and they state they never rec’d them, it didtn start until 2009. Didnt get finalized until May of 2014, so it took 5 years. Then last year, my 1098 showed I paid NO interest on my home, it was blank, all zeros, even MIP. Then 2 months later I recieve a letter from IRS stating we owe $2500??? I mailed them the 1098 showing we couldnt claim anything cause it was zero, IRS was taken care of, they stated we owe nothing. Then a month later, I get another 1098 in the mail from B of A showing I paid $19,000 in interest, so I had to amend my tax return. Now, in 2014, I get a 1098 showing I paid $9000 in interest, and also have $27,000 in refund of overpayment in interest?????? B of A states its all from 2013, which from what I’m told, I have to claim the $19,000 that was on my 1098 from last year as income on my tax return!!!!!!!
I would like to find out who to talk to to file against BOA. We modified in 2010. At least 2 other times I had to sign the documents again, 2 years later, because BOA screwed up. We filed bankruptcy in 2013 but still made normal payments. They would even change my account and post payments as misc. They finally would go back and fix it after I complained. On top of that, my 1098s ever since have been wrong. One year they said I had $0 interest paid, and that was 2 years later. The corrected 1098 sent over a year later, was 3 times less than what was actually paid. I ended up owing the IRS money from 2011 because BOA screwed up the 1098. I had BOA send me my transaction history. I manually calculated all of my interest paid, and the past 4 years do not even match what they have on the 1098. I have no idea who to contact to get any of it correct and I sure don’t want to owe the IRS again!
I would like to know about my loan. Modified in 2009 balance went from 165505 to 186000 then lost my job again and in 2012 I was approved as a veteran for the hardest hit fund. BOA received a check in the amount of 14458 dollars to bring my account current. They also got one year of payments in excess of 35000 dollars. They applied the initial payment mostly toward the interest. Is this legal?? Facing foreclosure at this point.
I am counsel for the class. The Court dismissed the action claiming the matter was in the exclusive jurisdiction to decide. Yet, in another case we filed a different Court dismissed the 6050 private right cause of action but left the claims in. That Court directed counsel to ask the IRS if the lender did it right and then the claims would proceed. The IRS declined the invitation stating it would give no ruling or opinion. Yet a third Court concluded the first court was wrong regarding the dismissal for exclusive jurisdiction, but also wanted an answer from the IRS. That Court did not like the IRS response to the first court and ordered us to make further inquiry. The IRS has also stated Plaintiffs could not get information regarding another taxpayer, the lender. So, we ask the lender that convinced the Court that the IRS should weigh in to permit the IRS to disclose how it reported the interest it was paid on its return and its 1098 filing reports. You guessed it! The lender refused the invitation.
All of this is absurd because every lender agrees the the interest is deductible to the taxpayer yet it claims there is no IRS guidance how the lender should report this. Nonsense! The law is clear. Interest is interest is interest and reportable on a Form 1098 in the year it is paid/received. A tiger does not lose its stripes. Neither does interest.
I am one of the lawyers representing the plaintiffs in the Smith v. BOA case. I am interested in speaking with anyone who has had a modification with any other lending institution about how it treats capitalized interest. My phone number is 213 700 5194. The banks are currently imploring the IRS to issue “guidance” on this issue so that they can try to argue in court that their mistake in “disappearing” such interest was in good faith. Call me at 213 700 5194.
Hello my name is Sherrie. I am in a modification that I was never informed that I was approved for. Now, they are taking the modification from me and saying I will not receive a 1098 although I did make payments last year. My number is 336 934 2909. I would like to know what my rights are because there is more to this story. I need help before they take my home. Jfcurtis08@aol.com
I got a loan modification on my rental property from BOA in December 2013. My unpaid deferred interest from missed payments was also added to my principal balance. Before now, August 5, 2016, I had never heard or read anything about unpaid deferred mortgage interest added to principal balance should or could be tax deductible. What is statute of limitations for filing an amended return? Have their been recent updates to this post dated January 8, 2015? If so, how can I access them?
Have there been updates to this post dated January 8, 2015 — just found it tonight, August 5, 2015.
I saw a letter from the IRS to a mortagagee in 2012 that was dis allowing deferred interest because they did not have a form 1098 for that amount. I had loan from Bank of America that were foreclosed and I received form 1099-As with deferred interest added to principal that had not been reported on a form 1098. I had a loan form bank of America that was transferred to Chase in 2009 and I sold it in 2010 and paid an additional $16,344 in deferred interest that was never reported to me. The Bank has refused to provide me with these forms. I never received class notice or forms in the Horn v Bank of America case and when I asked the Class Administrator for the tracking number of their mailing he quit responding to my Emails after writing earlier that all my loans were included.