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

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The Tax Court in Brief – June 13th – June 17th, 2022

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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:

Primary Holdings:

Key Points of Law:

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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