In a short sale after they were discharged and the trustee abandoned their home, the debtors were entitled to a mortgage interest deduction they didn’t actually pay in cash, the Ninth Circuit said over a dissent.
We will lay out the facts carefully, so readers will know whether the circumstances are similar to situations facing your clients. We will go light on the law, which may not be intelligible except to lifelong tax lawyers.
The Short Sale
A couple owned a home with a $745,000 mortgage. After the housing market collapsed, they filed a chapter 7 petition in 2010 and scheduled the home as having a value of $600,000.
The debtors received their discharges, and the trustee abandoned the home, meaning that the debtors retained title. As Circuit Judge Daniel Paul Collins said in his March 2 opinion, the discharge meant that bankruptcy converted the recourse mortgage into a non-recourse mortgage, because discharge ended personal liability.
Rather than foreclose, the lender agreed to a so-called short sale a year later. The home eventually sold for about $555,000, from which some $522,000 was paid to the lender toward satisfaction of the loan.
The lender credited about $115,000 to interest and the remainder to principal. The lender gave the debtors an IRS Form 1098 showing the payment of $115,000 in interest. The debtors took the deduction on their tax return.
The IRS disallowed the interest deduction and assessed additional tax. The debtors paid the additional tax after trudging unsuccessfully through the administrative process at the IRS.
The debtors filed a civil action seeking a refund of the additional tax. The district court dismissed the complaint under Rule 12(b)(6), but not on the ground that the IRS proposed.
Rather, the district court extended Estate of Franklin v. Commissioner, 544 F.2d 1045 (9th Cir. 1976), where the Ninth Circuit disallowed interest deductions in connection with purportedly debt-financed transactions that lacked economic substance.
Distinguishing Franklin
Judge Collins reversed and ruled that the debtors were entitled to a refund of the additional tax they paid. He began his opinion by laying out the facts in Franklin and distinguishing Franklin from the case on appeal.
In Franklin, the mortgage transaction was a fiction from top to bottom. The taxpayers purportedly bought the property at an inflated price that “demonstrably” exceeded fair market value. They paid $75,000 in mortgage interest up front and nothing over the next 10 years. By the way, the loan was nonrecourse from the outset.
Disallowing interest deductions, The Ninth Circuit held in Franklin that the transaction could not be treated as a bona fide sale ab initio.
Judge Collins went on to quote Franklin for saying that the opinion was limited to “substantially similar transactions.” The appeals court, he said, “reaffirmed 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.’” Franklin, supra, 544 F.2d at 1048.
Judge Collins said that the district court “erred in extending the principles of Estate of Franklin to short sales involving mortgages that were valid ab initio.”
Unlike Franklin, Judge Collins said the debtors had not originally acquired the home “in a transaction that lacked economic substance.” Quoting Franklin, he said that the fact that bankruptcy turned the debt into a nonrecourse obligation “‘does not deprive the debt of its character as a bona fide debt obligation able to support an interest deduction.’” Id. at 1049.
Having found Franklin inapposite, Judge Collins turned to the IRS’s alternative argument under I.R.C. § 265(a)(1). First, he said that a short sale involving nonrecourse debt does result in cancellation of indebtedness income that would trigger Section 265. Second, he concluded that the conversion of recourse debt into nonrecourse debt via discharge had no effect on the otherwise applicable tax treatment of the later short sale.
Sitting by designation from the District of Massachusetts, District Judge Richard G. Stearns “respectfully” dissented, believing that the majority opinion was “based on a fictional factual premise.” He said it was “simply not the case” that the debtors had paid the mortgage interest.
Still, Judge Stearns agreed with the majority regarding the inapplicability of Franklin. Rather, he believed that the “tax-exempt discharge of indebtedness within the meaning of I.R.C. § 108(a)(1)(A)[] preclude[ed] an interest deduction under I.R.C. § 265(a)(1).”
Note: Circuit Judge Daniel Paul Collins is not to be confused with Bankruptcy Judge Daniel Patrick Collins of Phoenix.
In a short sale after they were discharged and the trustee abandoned their home, the debtors were entitled to a mortgage interest deduction they didn’t actually pay in cash, the Ninth Circuit said over a dissent.
We will lay out the facts carefully, so readers will know whether the circumstances are similar to situations facing your clients. We will go light on the law, which may not be intelligible except to lifelong tax lawyers.