Mortgage Interest Deduction Denied Due to Uncertain Foreclosure Proceeds Allocation

(Parker Tax Publishing June 2022)

The Tax Court held that a couple whose residence was sold in a foreclosure could not claim a home mortgage interest deduction under Code Sec. 163(h) as a result of a sale by the buyer of the residence to third parties. Although a credit agreement between the lender and the taxpayers clearly stated that delinquent repayments were to be applied first to interest due from the taxpayers rather than to principal, the court found that the taxpayers failed to show how the buyer applied the funds received and whether the taxpayers owed any remaining principal balance. Howland v. Comm'r, T.C. Memo. 2022-60.

Background

In 2007, Ronald and Marilee Howland executed a credit agreement with Haven Trust Bank, consisting of a promissory note and mortgage secured by their principal residence, with respect to a line of credit up to $390,000 (credit agreement). This credit agreement in favor of Haven Trust Bank was secondary to the Howlands' first mortgage loan held by Countrywide Home Loans. Under the terms of the credit agreement held by Haven Trust Bank, the Howlands' payments were applied first to interest and then to principal.

Haven Trust Bank was closed in 2010 and entered receivership with the Federal Deposit Insurance Corporation (FDIC). The Howlands' loan with Haven Trust Bank was acquired by First Southern Bank. In June 2014, First Southern Bank merged with CenterState Bank. Since the Howlands had not made any payments on the Haven Trust Bank credit agreement, First Southern Bank filed a verified complaint in a state court for foreclosure (foreclosure complaint). When the foreclosure complaint was filed, the Howlands owed $377,060 in principal on the credit agreement, plus accrued interest, fees, and other charges. In the foreclosure action, First Southern Bank sought an award for the full amount due from the Howlands, including the right to foreclose on their residence based on the granted credit agreement.

The state court entered a summary final judgment, resulting in a foreclosure sale of the Howlands' residence in July 2016. CenterState Bank was the highest bidder at the foreclosure sale and acquired the residence with a bid of $321,000. At the time of the foreclosure sale, the sum of the accrued interest on the credit agreement was $100,607. In June 2016, a second foreclosure complaint regarding the Howlands' residence was filed by the first mortgage holder, Bank of New York Mellon, as successor in interest to Countrywide Home Loans. Bank of New York Mellon claimed a balance due of principal, interest, late charges, attorney's fees, and other permitted expenses of $247,046.

In December 2016, CenterState Bank sold the Howlands' residence to third parties for $594,000. No Form 1098, Mortgage Interest Statement, was issued to the Howlands for tax year 2016. There was no evidence in the record as to how the sale proceeds of $594,000 were applied to the Howlands' debts with First Southern Bank and Bank of New York Mellon.

On their joint Form 1040 for tax year 2016, the Howlands claimed a home mortgage interest deduction of $103,498 on Schedule A. Code Sec. 163(h) provides that home mortgage interest on indebtedness secured by a mortgage on a taxpayer's residence may be deductible as qualified residence interest (QRI). In a notice of deficiency, the IRS asserted that the Howlands were not entitled to take the home mortgage interest deduction and applied an accuracy-related penalty under Code Sec. 6662(a).

The Howlands challenged the notice in the Tax Court. They argued that CenterState, as successor in interest and holder of the promissory note, was contractually bound under the credit agreement to apply the foreclosure proceeds first to interest and second to principal. The IRS responded that of the $594,000 amount realized by CenterState, $247,046 of that went to pay off the Howlands' first mortgage, resulting in a net difference of $346,954 - which was less than the principal balance of $377,060 due to CenterState, and consequently the Howlands paid no interest. According to the IRS, the payment provisions found in the promissory note did not apply in the context of a foreclosure sale.

Analysis

The Tax Court sustained the IRS's determination to disallow the Howlands' home mortgage interest deduction. However, the court found that the Howlands were not liable for a penalty because they made a reasonable attempt to comply with the Code in circumstances involving a complex issue and therefore acted reasonably and in good faith with respect to the underpayment.

The Tax Court noted that in Lackey v. Comm'r, T.C. Memo. 1977-213, the court found that as a general rule, voluntary partial payments made by a debtor to a creditor are, in the absence of any agreement between the parties, to be applied first to interest and then to principal. However, in Newhouse v. Comm'r, 59 T.C. 783 (1973), the court found that an exception applies in the case of an involuntary foreclosure of mortgaged property where the evidence "strongly indicates" that the mortgagor is insolvent at the time of foreclosure. The court explained that, rejecting the interest first rule, it held in Newhouse and Lackey that no portion of the proceeds from either of the foreclosure sales therein was allocable to interest since the debtors were insolvent. On the other hand, in Estate of Bowen v. Comm'r, 2 T.C. 1 (1943), the Tax Court applied the proceeds from a foreclosure sale to interest first and then to principal where the debtor was not shown to be insolvent and the payments, in spite of the foreclosure, were voluntary.

In this case, the payments were not voluntary; however, there was no evidence that the Howlands were insolvent at the time of the foreclosure. Furthermore, unlike Lackey and Newhouse, the court said that this case involved a clear written agreement - the credit agreement - between the lender and the Howlands that repayments on the note were applied first to interest. Consequently, the court found its decisions in Lackey and Newhouse to be distinguishable.

The Tax Court agreed in part with the IRS's contention that CenterState did not realize the full $594,000, but rather received only $346,954 after the first mortgage was satisfied. However, the court found that it could not definitively conclude that CenterState received only the payment of principal from the Howlands. While it was undisputed that the principal balance due to CenterState was $377,060, under the terms of the credit agreement delinquent payments were to be first applied to interest due from the Howlands, rather than to principal.

The court concluded that the record before it was silent as to how CenterState applied the funds received and whether the Howlands owed any remaining principal balance. The court remarked that these facts (if favorable) could support a finding that the Howlands in fact paid home mortgage interest (in some amount) - rather than repaying principal balance. However, the court noted that statements in the briefs did not constitute evidence, and the court therefore concluded that the pertinent facts missing from the record meant that the Howlands failed to sustain their burden of proof.

For a discussion of the deduction for qualified residence interest, see Parker Tax ¶83,515.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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