Tax Court in Brief | Howland v. Commissioner | Mortgage Interest Deduction in Foreclosure Sale and Accuracy-Related Penalty

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Tax Litigation:  The Week of June 13th, 2022, through June 17th, 2022

Howland v. Commissioner, T.C. Memo. 2022-60 | June 13, 2022 | Weiler, J.| Dkt. No. 17526-19


Summary: In 2007, Ronald Howland, Jr. and Marliee Howland (together, Howland) executed a credit agreement with a 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). That credit agreement was secondary to a first mortgage loan held by another lender. Under the credit agreement, Howland’s payments were applied first to interest and then to principal. Howland defaulted on the credit agreement, and the bank filed a complaint for foreclosure. At the time, Howland owed $377,060 in principal on the credit agreement, plus accrued interest, fees, and other charges. In the foreclosure action, the bank sought an award for the full amount due, including the right to foreclose on Howland’s residence. In 2016, a foreclosure sale of Howland’s house was ordered, and the house was sold to purchaser bank for $321,000. At the time of the foreclosure sale, the sum of the accrued interest on the credit agreement was $100,607. Also in 2016, a second foreclosure complaint regarding Howland’s residence was filed by the first mortgage holder. That lender claimed a balance due of principal, interest, late charges, attorney’s fees, and other permitted expenses of $247,046. On December 30, 2016, foreclosure-purchaser bank sold the residence for $594,000. No Internal Revenue Service (IRS) Form 1098, Mortgage Interest Statement, was issued to Howland for tax year 2016 for the home mortgage interest in question. Howland timely filed a joint 2016 Form 1040, claiming a home mortgage interest deduction of $103,498 on Schedule A. On October 1, 2018, the IRS sent petitioners an automatically generated Letter 566–S and Form 14809, Interest You Paid, requesting an explanation of the claimed home mortgage interest deduction. In response, Howland provided the IRS with documents. Revenue Agent (RA) examined the 2016 Form 1040 and completed the “Penalty Substantial Understatement Lead Sheet” (penalty lead sheet). On May 9, 2019, the IRS issued to Howland IRS Letters 692–M and 937(SC), including Form 4549, Income Tax Examination Changes, and Form 886–A, Explanation of Items, and RA’s immediate supervisor approved the penalty lead sheet on that same day.

Key Issues:

  • Based on a set of stipulated facts, the issues for decision are (1) whether Howland is entitled to a home mortgage interest deduction of $103,498 claimed on Schedule A, Itemized Deductions, of their Form 1040, U.S. Individual Income Tax Return, for tax year 2016 and (2) whether Howland is liable for the accuracy-related penalty under section 6662(a).

Primary Holdings:

  • While the credit agreement provided that repayments on the note were to be applied first to interest and then principal, Howland failed to present sufficient evidence to show that the amount paid by the purchaser bank through the foreclosure sale was applied by the lender bank first to interest (and not to principal) owed by Howland under the credit agreement. The record was silent as to how the purchaser bank applied the funds received and whether Howland owed any remaining principal balance. Thus, the interest deduction was not allowed.
  • Howland made a reasonable and good faith attempt to comply with the tax requirements in circumstances involving a complex issue. The court found that Howland should not be assessed an accuracy-related penalty under section 6662(a).

Key Points of Law:

  • Burden of Proof. Generally, the IRS’s determinations are presumed correct, and the taxpayer bears the burden of proving them erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). The burden of proof may shift to the IRS if the taxpayer establishes that he or she complied with the requirements of section 7491(a) to substantiate items, to maintain required records, and to cooperate fully with the IRS’s reasonable requests.
  • Interest Deduction. Generally, a taxpayer may claim a deduction for “all interest paid or accrued within the taxable year on indebtedness.” R.C. § 163(a). Home mortgage interest on indebtedness secured by a mortgage on a taxpayer’s residence may be deductible as qualified residence interest (QRI). I.R.C. § 163(h)(2)(D), (h)(3). Interest is deductible only when paid or accrued during the tax year. See I.R.C. § 163(a). A cash basis taxpayer can deduct interest only when paid, either by cash payment or its equivalent (including transferring property to the lender in payment). Helvering v. Price, 309 U.S. 409 (1940); Hilsheimer v. Commissioner, T.C. Memo. 1976-284, 35 T.C.M. (CCH) 1275.
  • Interest Amount Paid. Interest is defined as a “compensation for the use or forbearance of money.” Deputy v. du Pont, 308 U.S. 488, 498 (1940). The general rule in this area is that 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. See Lackey v. Commissioner, T.C. Memo. 1977-213, 36 T.C.M (CCH) 890. However, an exception to this “interest first” general rule exists 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. See Newhouse v. Commissioner, 59 T.C. 783, 789 (1973).
  • Section 6662(a) Accuracy-Related Penalty. The accuracy-related penalty does not apply to any portion of an underpayment if it is shown that there was reasonable cause for the taxpayer’s position and that the taxpayer acted in good faith with respect to that portion. R.C. § 6664(c)(1); Treas. Reg. § 1.6664-4(a). The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all the pertinent facts and circumstances, the most important of which is the extent of the taxpayer’s effort to assess his or her proper tax liability for the year. Treas. Reg. § 1.6664-4(b)(1). The taxpayer bears the burden of proof with respect to reasonable cause. Higbee v. Commissioner, 116 T.C. 438, 446 (2001).

Insights: In the context of applying the mortgage interest tax deduction rules for amounts paid by a purchasing entity in a foreclosure sale that extinguishes an underlying loan debt, the “interest first” versus involuntary payment of interest is determined by evaluation of the underlying loan, mortgage, or credit agreements as well as how the purchase money is applied by the receiving creditor in foreclosure. A taxpayer must present sufficient evidence for the IRS and ultimately the Tax Court to conclude that a portion of foreclosure sale proceeds were in fact applied to interest owed by the taxpayer. And, the taxpayer must not be insolvent at the time; otherwise, the payment of interest may be deemed “involuntary” and thus a deduction not available under the “interest first” rule.

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