Introduction
In the previous issue of The St. Louis Bar Journal, we talked about a U.S. Tax Court Memorandum Decision1 granting the Internal Revenue Service Commissioner a partial summary judgment denying the taxpayer the benefit of the Section 121 exclusion2 from capital gains taxation of a portion of the proceeds of the sale of her residence, because she had not lived in it for at least 2 of the 5 years preceding the sale, and had in fact rented it out over much of that time period.3
That case is still awaiting a trial setting on other issues, and while it is possible the gains exclusion question will eventually be appealed, for reasons we suggested at the time this seems unlikely.
Today we consider a tangentially related question: that is, whether and to what extent a taxpayer may be allowed a deduction for payment of residential mortgage interest where the residence is sold at foreclosure for less than the outstanding principal balance of the mortgage loan.
Basic Principles
As most readers probably know, a taxpayer is allowed an itemized deduction4 for at least some portion of interest paid on debt secured by a mortgage on the principal residence and/or one other residence. This is an exception to the general rule5 that a taxpayer may not deduct interest paid on “personal,” i.e., nonbusiness, debt.6
But the deduction is limited to interest paid on the first $1.0 million7 in “acquisition indebtedness,” which means essentially what it says, and up to another $100,000.008 in “home equity indebtedness,” up to the fair market value of the residence, minus acquisition debt.9
As part of the 2017 tax bill,10 the limitation on acquisition debt has been temporarily reduced, through December 31, 2025, to $750,000.00.11 That limitation applies only to debt incurred after December 15, 2017.12
In the absence of an agreement to the contrary, each partial payment toward a mortgage loan is to be allocated first to interest and then to principal.13 But there is an exception 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.14
In that event, the rule is exactly the opposite: the creditor is not treated as receiving any interest income, and, correspondingly, the debtor is not allowed an interest deduction, except to the extent the fair market value of the property taken in foreclosure exceeds the principal debt.15
The Case at Hand
All of which brings us to the present case, Howland v. Commissioner,16 decided in June 2022.
In mid- to late 2007, just as the financial crisis was starting to unfold, Dr. Ronald W. Howland, Jr. had borrowed not quite $400,000.00 to build out and equip the office space for his dental practice in St. Johns County on the Atlantic coast of Florida. Although the nominal borrower was his professional corporation, the note was guaranteed by Dr. Howland individually and secured by a second mortgage on the residence he owned as tenants by the entirety with his wife, Marilee R. Howland.17 This was a five-bedroom house, almost 5,000 square feet, also in St. Johns County, which the Howlands had bought in the mid-1990s for less than $80,000.00. Clearly, it had appreciated substantially in value over the years.
But Dr. Howland made no payments on the loan. Eventually, the lender went into receivership, and in 2014 its assets, including Dr. Howland’s mortgage note, were acquired by another bank, which promptly initiated a judicial foreclosure.
In 2016, the court entered summary judgment for the bank for the full amount due, principal and interest, and ordered a foreclosure sale. The bank itself was the successful bidder, at a price about $50,000.00 below the outstanding principal balance on the loan. At the time, accrued interest on the loan was some $100,000.00. Shortly thereafter, the holder of the first mortgage also filed a foreclosure action, seeking about $250,000.00 in principal, interest, and attorneys’ fees and other expenses.
Ultimately, the property was sold to a third-party purchaser for just under $600,000.00, leaving the junior lender with somewhat more than it had bid at its foreclosure sale, but still less than the principal balance on its loan. There was no evidence in the record before the Tax Court how the proceeds were allocated, and neither of the lenders issued a Form 1098—Mortgage Interest Statement to the Howlands indicating that any specific amount was credited to interest on either loan.
On their joint tax return for 2016, the Howlands reported $100,000.00 as a mortgage interest deduction, representing the amount that had accrued on the line of credit secured by the second mortgage. The IRS disallowed the deduction and asserted a 20% penalty for substantial understatement of income tax.18
The case was submitted without trial, on a stipulation of the facts.19
Be Careful What You Stipulate
As it happened, the stipulation cut both ways. The Commissioner argued that the sale proceeds should be deemed to have been applied first to principal, but Judge Christian Weiler noted that the stipulation included no evidence that the Howlands were insolvent,20 and the agreement with the lender specified that payments were to be applied first to interest.
On the other hand, the stipulation also did not include, as Judge Weiler put it, “how [the lender] applied the funds received [from the third-party sale] and whether petitioners owe any remaining principal balance.”21 Although “[t]hese facts (if favorable) could support a finding that petitioners in fact paid home mortgage interest (in some amount),” he said, the Howlands had failed to carry their evidentiary burden on this point.22
In other words, in the absence of affirmative evidence of how the lender had applied its share of the proceeds of the third-party sale on its own books, the Howlands should be allowed no mortgage interest deduction at all, regardless of the fact that a loan agreement itself provided that payments were to be applied first to interest.
At least one commentator23 has also observed that the foreclosure judgment itself would have included a breakdown of how proceeds were to be applied.
Conclusion
The decision seems clearly wrong, in other words. But at this writing, the final, computational decision had not yet been entered,24 and the taxpayers had not yet filed a Nnotice of Appeal.
On the plus side, the Tax Court determined that the Howlands’ reporting position was “reasonable,” so that the underpayment penalty should not apply.25 In arriving at this determination, the Court said the Commissioner “has not referred us to, nor have we found, any cases that have directly answered the question” whether an interest deduction was allowable in these circumstances.26
1 Webert v. Commissioner, T.C.Memo. 2022-32 (April 7, 2022).
2 26 U.S.C. § 121(a).
3 See Richard M. Wise, Postponing the Inevitable, The Saint Louis Bar Journal, Vol. 69, No. 1 (Summer 2022).
4 26 U.S.C. § 163(h)(3).
5 26 U.S.C. § 163(h)(1).
6 Some longtime readers may remember that prior to enactment of the Tax Reform Act of 1986, Pub.L. 99-514 (10/22/86), interest on personal debt was fully deductible.
7 Or $500,000.00 in the case of a married taxpayer filing separately.
8 Or $50,000.00 in the case of a married taxpayer filing separately.
9 Per 26 U.S.C. § 163(h)(3)(d), any mortgage debt incurred prior to October 13, 1987, is treated as “acquisition indebtedness, and the $1.0 million limit does not apply. The referenced date is when language to this effect was first introduced in the House in a precursor to the bill that eventually became the Omnibus Budget Reconciliation Act of 1987, Pub.L. 100-203 (12/22/87).
10 Tax Cuts and Jobs Act, Pub.L. 115-97 (12/22/17).
11 Or $375,000.00 in the case of a married taxpayer filing separately.
12 Again, the date on which language to this effect was first introduced in the Conference Report, H.Rept. 115-466.
13 Story v. Livingston, 38 U.S. 359, 371 (1839).
14 Newhouse v. Commissioner, 59 T.C. 783, 789 (1973).
15 See Lackey v. Commissioner, T.C.Memo. 1977-213 (July 12, 1977), and cases cited therein.
16 T.C.Memo. 2022-60 (June 13, 2022).
17 Some of the details recited in this and later paragraphs come, not from the Tax Court opinion, but from other sources including the foreclosure proceedings, the St. Johns County property tax assessor and recorder of deeds, and the later bankruptcy proceedings. 18 26 U.S.C. § 6662(b)(2).
19 Per Rule 122, Tax Court Rules of Practice and Procedure.
20 When the Howlands individually filed a Chapter 7 bankruptcy two years later, they reported nonexempt assets of not quite $56,000.005, and liabilities of over $1.1 million, including the unsecured balances of these two mortgage loans.
21 Howland, supra note 16, at 7.
22 Id.
23 See Noteworthy, taishofflaw.com/2022/06/13/noteworthy/.
24 Howland v. Commissioner, No. 17526-19, accessible at ustaxcourt.gov.
35 Howland, supra note 16, at 8-9.
26 Id. at 8.