Tim’s Tax News on the Tenth – March 2022

Bankruptcy law often intersects with numerous other areas of law, and understanding the intricate rules and how they intersect may be used to one’s advantage. In a recent Ninth Circuit Court of Appeals case, the Court (over a dissent) reversed the trial court and ruled that a couple was entitled to a refund of the additional tax they paid on the short sale of their home.

The relevant facts: A couple owned a home with a $745,000 mortgage. After the housing market collapsed, they filed for chapter 7 bankruptcy protection in 2010 and scheduled their home as having a value of $600,000. Because the value of the home was well below the amount of the lender’s (“CitiMortgage”) secured lien, the bankruptcy trustee abandoned the home because there was no property available for distribution from the estate (over and above that exempted by law) to other creditors. As a result, the couple was able to retain legal title to their home. Rather than foreclose, CitiMortgage agreed to a short-sale and the home eventually sold for $555,000, from which $522,015 were paid to CitiMortgage toward satisfaction of the loan.

When the couple’s bankruptcy petition was discharged, their mortgage loan changed from “recourse” to “nonrecourse.” This eliminated CitiMortgage’s pre-existing ability to enforce the mortgage debt personally against the couple, and instead limited CitiMortgage to enforcing only the value of its lien. After receiving the $522,015 from the short sale, CitiMortgage credited $114,688 of it toward the accumulated unpaid interest on the secured loan and credited the remaining amount toward paying off the loan principal. When the couple filed their taxes that year, they then claimed that $114,688 mortgage interest deduction on their tax return.

The IRS, however, disallowed the deduction under I.R.C. § 265(a)(1), and assessed additional tax, claiming the couple “did not establish that the amount . . . was (a) interest expense, and (b) paid.” After objecting and losing at the administrative process with the IRS, the couple paid the additional tax but filed a lawsuit against the IRS seeking a refund of the additional tax.

It was a long battle. At first, the district court dismissed the couple’s complaint under Federal Rule of Procedure 12(b)(6). In dismissing the action, the court did not rely on the rationale the IRS had invoked. Instead, the court reasoned that, although “interest deductions are generally allowed,” Plaintiffs’ interest payments fell under an exception established in Estate of Franklin v. Commissioner, 544 F.2d 1045, 1048-49 (9^th Cir. 1976), for interest claimed in connection with purportedly debt-financed transactions that lacked economic substance, reasoning that although Plaintiffs were unlike the taxpayers in Estate of Franklin (who had acquired their debt liability in a transaction that lacked economic substance), that precedent applied to validly issued mortgages that later resulted in short sales in which “the nonrecourse liability (here, the mortgage) exceeds a reasonable estimate of the fair market value of the indebted property.” Since the fair market value of the home had declined to well below the mortgage balance, the court concluded that the “transaction” lacked economic substance and any interest deduction was barred.

The couple timely appealed the district court’s decision and the battle continued in the Court of Appeals, which ultimately held that the couple was entitled to deduct the mortgage interest paid in connection with the short sale of their home, reasoning the district court had erred in extending the principles of Franklin to the short sale because the mortgage was valid ab initio.

In other words, when the couple first purchased their home, their mortgage-financed purchase was a valid sale and neither that transaction nor their subsequent refinancing lacked economic substance. See Beck v. Commissioner, 678 F.2d 818, 820 (9^th Cir. 1982). The court reasoned that a subsequent collapse in real estate values did not mean the couple’s initial mortgage had been a sham. It also noted that the fact that the couple’s mortgage became nonrecourse (as a consequence of their bankruptcy) “does not deprive the debt of its character as a bona fide debt obligation able to support an interest deduction.” See Estate of Franklin, 544 F.3d at 1049. Also, unlike in Estate of Franklin, the couple had remained the legal owners, with actual possession of the home until it was sold in the short sale.

In short, since the couple’s short sale of their home involved a nonrecourse debt, the transaction did not give rise to a cancellation-of-debt income that might trigger the application of § 265. Moreover, since the couple’s bankruptcy discharge had converted the mortgage from recourse to nonrecourse a year before the short sale, it had no effect on the applicable tax of the short sale.

If you would like more details, please do not hesitate to call our office. Our office has been successful in helping taxpayers with IRS and IDOR collection problems for over 29 years. If you have a tax or debt problem, please contact me at 847-705-9698 or thughes@lavellelaw.com and find out how we can help you.

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Lavelle Law, Ltd. is registered with the Illinois Department of Financial and Professional Regulation as an approved continuing education provider for CPE for CPAs and Enrolled Agents. If your organization is seeking CPE courses in the area of Business Law, Innocent Spouse Relief, IRS Collections, Tax Scams (including ID Theft), or other areas in tax law that can be taught at your office, please contact me at thughes@lavellelaw.com