Copeland v. C.I.R., 2014 WL 5483046 (Tax Ct. 2014), mentioned in Les’ earlier blog post and which he separately blogged In Living With Your Decisions: Delinquent Mortgage Debt also expressly holds that pre-loan modification interest retains its character as mortgage interest even after a loan modification and is therefore deductible by taxpayers in the year of repayment:

Through the loan modification agreement, the $30,273 in past-due interest on petitioners’ mortgage loan was added to the principal [“capitalized”]. 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”(emphasis added).

The principal of tax law that Copeland relies upon is not new. The Tax Court in Motel Corporation v. Comm. of Internal Revenue, 54 T.C. 1433 (1970) found in the context of late-paid interest that it retained its character as interest. As that court put it: “we can perceive no reason why defaulted interest should be transformed into principal for purposes of tax law.” In the context of a “negative amortization” pay option ARM loans, the Tax Court in Smoker v. C.I.R., 2013 WL 645265 (Tax Ct. 2013) also squarely held that deferred interest does not lose its character as mortgage interest simply because it is capitalized and added to principal; rather, capitalized interest is deductible in the year of payment.

Revenue Ruling 77-135, governing the treatment of deferred interest paid on “Graduated Payment Mortgages” (“GPMs”), also supports the position that capitalized mortgage interest does not lose its character as mortgage interest simply by being added to principal. GPMs are negative amortization loans like that which was at issue in Smoker, but instead of offering the customer an “option” to pay less than the interest due in any given month, they instead provide for a fixed schedule of payments which, in the early years of the mortgage, are for less than the interest actually due, but as the mortgage term continues, the payments “graduate” to recover the interest that was previously deferred. Revenue Ruling 77-135 explicitly holds that for cash basis taxpayers like the overwhelming majority of taxpayers, “…when the amount of the payments has increased to the extent that it now exceeds the current interest charge owed, the excess… will be treated as discharging first that part of the unpaid balance of the loan that represents accumulated interest carried over from prior years and will be included in income by the mortgagee and deducted by the mortgagor as interest at that time” (emphasis added).

We have argued that since there is already a revenue ruling applying the principle that capitalization of interest does not change its character as interest, and since section 6050H unambiguously requires that all types of interest be “aggregated” as part of the Form 1098 reporting calculation, there is no reason for the Service to provide any further “guidance” in response to the MBA’s and ABA’s “questions.” The answer is plain for all to see.

The Service Itself Has Essentially Accepted Our Position in Related Issues

Indeed, this is exactly what the Service found when it enacted 26 C.F.R. Section 1.221-2(h) – capitalized student loan interest (post-2004) should be reported on Form 1098-E along with current interest in the year in which it is paid. The Treasury Department’s stated rationale for its determination that capitalized student loan interest should be reported on Form 1098-E in the year in which it is paid is exactly the same as we have been arguing all along here, namely that:

“Courts have defined the term ‘interest,’ for income tax purposes, as compensation paid for the use or forbearance of money. See, e.g., Deputy v. Du Pont, 308 U.S. 488 (1940). Consistent with this definition, the final regulations provide that capitalized interest is deductible as qualified education loan interest… Under the final regulations, a payment generally first applies to interest that has accrued and remains unpaid as of the date the payment is due and then applies to the outstanding principal.

See 69 FR 25489-02, 2004 WL 972762 *25490.

There is absolutely nothing to logically distinguish the reporting treatment of capitalized interest in the student loan context and the treatment of capitalized interest in the mortgage/loan modification context. Therefore, even if there was still some question of ambiguity remaining after Revenue Ruling 77-135 as to the treatment of capitalized interest, after 2004 no bank could reasonably claim that it needed further “guidance” on whether to report the payment of capitalized interest on an informational return.

Back to Why the Bankers’ Views are Wrong

The American Bankers Association’s letter repeatedly, and misleadingly, uses the term “new loan” with reference to loan modifications. It does so because where a borrower truly obtains a new loan, then all of the pre-existing interest is paid off and there is no question of reporting payments of pre-existing interest. But a loan modification is not a “new loan.” It is a modification of an existing loan. And, in a loan modification, pre-existing interest is not paid off, but is capitalized and thus cannot be made to simply “disappear” for the bank’s convenience.

It is a “fundamental proposition of tax law that in determining the tax treatment of a transaction, substance governs form.” Gregory v. Helvering, 293 U.S. 465, 470 (1935). In fact, it was based on this very premise that Copeland held that loan “modifications” are not “new notes” for purposes of calculating mortgage interest:

[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… Contrary to petitioners’ “substance over form” argument, the transaction they hypothesize is not economically equivalent to the transaction in which they engaged… 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.

The American Bankers Association (“ABA”) likewise should not be allowed to recharacterize the loan modification transactions in which its members “actually engaged” into “new loans.” Loan modification agreements all make very clear that the transaction is not intended to create a “new note,” but is intended to “amend” and/or “supplement” the original note. They also all require their borrowers to continue to comply with all of the requirements of the original notes except for the specifically modified provisions. But what really puts the lie to the ABA’s “new loan” claim is that the loan modification agreements themselves expressly declare that they are not to be so construed. For example, Bank of America’s loan modification form states that “Nothing in this agreement shall be understood or construed to be a satisfaction or release in whole or in part of the Note (referring to the original note) and Security Instrument (referring to the original deed of trust).” Bank of America also, notably, continues to use the same “old” loan number post modification and we are certain other lenders do as well. There is no way given the text of the loan modification agreements that any borrower would ever anticipate that banks would take the position that the agreements they signed were modifications in every respect except that they were entering into “new loans” for the purpose of pre-existing interest. Nor did any of the loan modification agreements advise borrowers that the banks would not be reporting this interest on Form 1098 and that they would effectively be giving up their mortgage deduction or, at the very least, forcing them to battle with the Service every year because their stated deductions would not match the Form 1098 issued by their lender.

Further demonstrating that plaintiffs’ loan modifications are not “new notes” is that no new Truth in Lending Act (TILA) disclosures under 15 U.S.C. §§ 1631, 1632, 1635 and 1638 are given to loan modification recipients. 12 C.F.R. § 226.20 requires that new TILA disclosures must be given when a lender enters into a subsequent transaction with an existing borrower; it provides that where the subsequent transaction amounts to replacing the original obligation with a “new obligation,” then the subsequent transaction is a “refinancing” and new TILA disclosures must be provided. The Official Staff Interpretation, Supp. I to 12 C.F.R. § 226.20(a) confirms that only “the cancellation of [the original] obligation and the substitution of a new obligation amount to a refinancing.” And that:

A refinancing is a new transaction requiring a complete new set of disclosures. Whether a refinancing has occurred is determined by reference to whether the original obligation has been satisfied or extinguished and replaced by a new obligation, based on the parties’ contract and applicable law. The refinancing may involve the consolidation of several existing obligations, disbursement of new money to the consumer or on the consumer’s behalf, or the rescheduling of payments under an existing obligation. In any form, the new obligation must completely replace the prior one.”   (Emphasis added).

Thus, while the ABA members could certainly have offered their borrowers in distress “new loans”, the fact is that they chose the entirely different route of loan modification and they did so for their own interest. Having done so, they should be made to live with that choice.

Bank of America has tried to rely on Revenue Ruling 70-647, 1970-2 C.B. 38 as a justification for foisting onto borrowers the responsibility for tracking payments of the interest they owed prior to their loan modification’s taking effect. That Revenue Ruling states that where a:

lender accepts a new note (emphasis added) in payment of remaining principal and interest due on an existing note,… it is incumbent on the individual to keep his own record of [his payments of the part of the new loan balance that is interest accrued on the original loan].

This is clearly the source of the ABA “new” loan language. But quoting a phrase does not necessarily make it fit; by its very terms, the Ruling applies only where “a lender accepts a new note in payment, i.e. in full satisfaction of the remaining principal and interest due on [an] existing note.” (Emphasis added). Indeed, the phrase “new note” as a restriction appears no fewer than 6 separate times in the text of the short Revenue Ruling.Since the ABA’s letter involves loan modifications and not “new notes,” Revenue Ruling 70-647 has no application to the loan modification issue presented by the ABA letter.

Conclusion

As can be seen from all of the above, there is overwhelming existing authority pointing to the conclusion that: (1) 26 U.S.C. Section 6050H unambiguously requires recipients of more than $600 in mortgage interest to report the “aggregate” amount of the interest they receive during the calendar year, i.e. the sum of all types of interest they receive; (2) capitalizing mortgage interest and adding it to principal does not change its character as mortgage interest such that, just as with student loans, payments of capitalized interest must be reported on Form 1098 when it is paid; and (3) loan modifications do not present any exception to this rule; they are not new loans, but are just what they purport to be: modifications of existing loans. Neither the ABA nor MBA letters offer any authority that would support an alternative view. We have argued therefore that there is thus no need for further “guidance” on what is a well-worn set of principles of tax law.

However, we have argued that if the IRS determines to issue some sort of “guidance,” it should not make it a “get out of jail free card” for the banks. While the banks would like a prospective-only guidance of the type issued back in 2004 with regard to how to treat capitalized student loan interest, there is absolutely no reason to do that in this case where the law has been clear (since at least that time) that capitalized interest is still interest and thus should be reported.

Taxpayers have suffered greatly because of what is at least incompetence, and more likely simply a decision that tracking such interest was too expensive to bother with for the banks. Indeed, the only reason the MBA and ABA are bothering with this issue now is because we caught its members doing it wrong. We are thus hopeful that the IRS will not simply aid the banks in the currently pending litigation by declaring an ambiguity in the law that it has itself said in 2004 does not exist.

Finally, we have argued to the IRS that whatever it decides to do, its action should do whatever it can to allow tax-payers to obtain the benefit of the billions of dollars in tax deductions that at least some of the ABA/MBA member banks have chosen (and “chosen” is a very deliberate word) to deny them out of their desire for expediency and cost reduction.

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 9^th 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.