The Ninth Circuit Court of Appeals (the Court) allowed former chapter 7 debtors to deduct from their taxes the interest credited as paid to the lender from the proceeds of a short sale, overruling a determination by the Internal Revenue Service that they were not entitled to the interest deduction. The majority ruled that the bankruptcy discharge, which converted the debt from recourse to nonrecourse, had no effect on the debtors’ right to the deduction, whereas a strong dissent would have concluded to the contrary. Milkovich v. United States, 2022 WL 610295 (9th Cir. 3/2/22).
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Plaintiffs Lisa Milkovich and Dang Nguyen (Plaintiffs) purchased a home in Renton, Washington in 2005, with a purchase money mortgage; the mortgage was refinanced in the principal amount of about $750,000 a year later. In 2010, the Plaintiffs filed a chapter 7 bankruptcy. By then, their home was underwater and abandoned by the trustee as having no value for unsecured creditors. The Plaintiffs received a discharge which included their personal liability on the mortgage, converting the recourse debt to nonrecourse.
The Plaintiffs defaulted on the mortgage. Rather than foreclose, the lender Citimortgage agreed to a short sale in July 2011. A portion of the proceeds received from that sale were allocated to the accrued interest on the loan of $114,688. Citimortgage issued a Form 1098 Mortgage Interest Statement, which the Plaintiffs filed along with their 2011 tax returns, claiming the interest deduction reflected by the Form 1098. The IRS rejected the interest deduction, issuing a notice of deficiency that was mailed to the Plaintiffs at the wrong address in 2014. They eventually learned of the notice and pursued administrative steps to overturn the deficiency. The administrative appeal was finalized in 2018 with no change in the IRS’s position. They then paid the tax assessed and filed a claim for a refund. After no response from the IRS, the Plaintiffs filed suit in the district court, seeking the refund. The district court granted the IRS’s motion to dismiss without leave to amend. In the resulting appeal, the Court reversed.
The district court’s dismissal had turned on its interpretation of an earlier Ninth Circuit opinion, Estate of Franklin, 544 F. 2d 1045 (9th Cir. 1976), where the Court had concluded that a partnership’s purchase of a motel for an inflated price financed by a nonrecourse loan lacked economic substance, did not give rise to a “genuine indebtedness”, and therefore could not support an interest deduction. The Court found reliance on Franklin on these facts was misplaced. Whereas in the earlier case, the financing from the outset was bogus without any real economic substance, the Plaintiffs’ loan was valid ab initio, because the consideration paid for the home was fair market value and the indebtedness for the purchase was legitimate. The Court therefore applied the “ordinary rule that the absence of personal liability for the purchase money debt secured by a mortgage on the acquired property does not deprive the debt of its character as a bona fide debt obligation able to support an interest deduction,” a rule which Franklin had reaffirmed.
The Court then rejected various arguments from the IRS, too deep into details of tax law to be discussed here, concluding that the “Plaintiffs’ bankruptcy discharge, which converted the mortgage from recourse to nonrecourse…, had no effect on the otherwise applicable tax treatment of the later short sale.” It ultimately applied what it referred to as “the normal rules that govern short sales concerning nonrecourse debt” and concluded that the Plaintiffs were entitled to deduct the interest which Citimortgage received from the short sale. The dismissal was reversed, with the holding that Plaintiffs were entitled to the deduction.
The dissent took issue with the fictionalized concept that the Plaintiffs had actually paid the interest: “It is simply not the case…that appellants… ‘paid’ the mortgage interest for which they sought a tax deduction, and no amount of ‘deeming’ it so can make it otherwise.” It distinguished the cases relied upon by the majority and embraced the IRS’s arguments, which centered on the assertion that when a seller of property can never recognize a taxable gain (because of the bankruptcy discharge or other reasons) it should also never be entitled to an offsetting deduction, such as the interest deduction here.
This opinion is certainly good news for debtors who have sold property in a short sale where their lenders issued Form 1098’s for interest credited from that sale. I am not a tax expert and have no real expertise to speak about the arguments asserted by the IRS, but there is some logic to the dissent’s reasoning. It does seem to me that the “payment” of interest is a fiction under these circumstances. In addition, when I was taking tax classes in law school, I remember one repeated principle: where the IRS gives a deduction or “break” so that tax is not owed right now, there is usually a quid pro quo where the tax is really only deferred, not eliminated, or someone else must pay it; i.e., what they give away, they get back. Therefore, the reasoning applied by the IRS and the dissent, which would deny the deduction in a transaction where no taxable gain can ever be calculated, seems like an argument which is consistent with other tax policies.
But who am I to say? Debtors, enjoy your victory.
This review was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. Ca., Ret.), a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.