Marilee Howland and Ronald Howland, Jr. (collectively, Howland) signed a credit agreement with a bank in 2007 for a line of credit of up to $390,000 that was secured by their primary residence. The deal also included a promissory note (credit agreement).
Due to a first mortgage loan held by another lender, that credit agreement was subordinate. Howland’s payments were split between interest and principal as per the terms of the loan agreement.
Howland broke the terms of the credit agreement, thus the bank complained about foreclosure. Howland’s balance under the credit agreement at the time was $377,060 in principal plus accrued interest, fees, and other costs.
The bank requested a judgement for the full sum owed, along with the power to seize Howland’s home, in the foreclosure proceeding. Howland’s home had to be sold in foreclosure in 2016, and the bank that bought it paid $321,000 for it.
The amount of interest on the credit agreement that had accumulated as of the foreclosure auction was $100,607. Additionally, in 2016, the first mortgage holder filed a second foreclosure lawsuit involving Howland’s home.
That lender asserted that there was a $247,046 amount outstanding on principal, interest, late fees, attorney costs, and other allowed expenses. The house was sold by a bank acting as a foreclosure purchaser on December 30, 2016, for $594,000.
Howland did not receive a Form 1098, Mortgage Interest Statement, from the Internal Revenue Service (IRS) for the tax year 2016 about the mortgage interest in question. Howland correctly submitted a joint 2016 Form 1040 with a Schedule A claim for a deduction for $103,498 in home mortgage interest.
The IRS sent petitioners a Form 14809, Interest You Paid, and an automatically generated Letter 566-S on October 1, 2018, asking them to provide justification for the claimed home mortgage interest deduction. Howland responded by giving the IRS some paperwork.
The revenue Agent (RA) completed the “Penalty Substantial Understatement Lead Sheet” after reviewing the 2016 Form 1040. (penalty lead sheet).
The IRS sent Howland IRS Letters 692-M and 937(SC) on May 9, 2019, along with Forms 4549, Income Tax Examination Changes, and Form 886-A, Explanation of Items. On the same day, the lead sheet for the penalty was also approved by RA’s immediate supervisor.
Key Concerns:
The issues for decision are (1) whether Howland is entitled to the deduction for home mortgage interest of $103,498 claimed on Schedule A, Itemized Deductions, of their Form 1040, U.S. Individual Income Tax Return, for the tax year 2016, and (2) whether Howland is accountable for the accuracy-related penalty under section 6662. (a).
First Holdings:
While the credit agreement stipulated that payments on the note should be made first to interest and then principal, Howland failed to provide enough proof to demonstrate that the money paid by the buyer 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.
How the purchaser bank used the money it received and if Howland still owed any unpaid principal were not included in the document. As a result, the interest deduction was not permitted.
Howland made a fair and sincere effort to abide by the tax regulations despite the challenging conditions. The court determined that section 6662’s accuracy-related punishment should not be applied to Howland (a).
Law’s Main Points:
Charge of Proof. In most cases, the IRS’s conclusions are assumed to be accurate, and it is the taxpayer’s responsibility to show otherwise. 142(a) of the rules; Welch v. Helvering, 290 U.S. 111, 115 (1933).
If the taxpayer proves that they complied with section 7491(responsibilities ) to support claims, keep necessary records, and fully cooperate with the IRS’s reasonable demands, the burden of proof may shift to the IRS.
Discount for interest. In general, “all interest paid or incurred on debts during the taxable year” is deductible by taxpayers. R.C. § 163 (a). A taxpayer may deduct qualifying dwelling interest on home mortgage interest on debt secured by a mortgage on their primary house (QRI). 163(h)(2)(D), (h) of the IRC (3).
The only interest that has been paid or accrued throughout the tax year is deductible. IRC 163 is cited (a). Only when paid, either in cash or its equivalent, can an individual using the cash basis deduct interest (including transferring property to the lender in payment).
309 U.S. 409 (1940); Hilsheimer v. Commissioner, T.C. Memo. 1976-284, 35 T.C.M. (CCH) 1275; Helvering v. Price.
Interest is paid in dollars. “Compensation for the use or forbearance of money” is the definition of interest. 308 United States 488, 498 (Deputy v. du Pont) (1940). In this case, it is generally accepted that any voluntary partial payments made by a debtor to a creditor should be allocated first to interest and then to the principal in the absence of a prior agreement between the parties.
For more information, see Lackey v. Commissioner, T.C. Memo. 1977-213, 36 T.C.M (CCH) 890. There is, however, an exception to the general rule that “interest comes first” when there is an unjustified foreclosure of a mortgaged property and the evidence “highly indicates” that the mortgagor was bankrupt at the time of the foreclosure.
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The “interest first” versus “involuntary payment of interest” distinction is made in the context of applying the mortgage interest tax deduction rules for sums paid by a purchasing entity in a foreclosure sale that cancels an underlying loan debt by assessing the underlying loan, mortgage, or credit agreements as well as how the purchase money is used by the receiving creditor in foreclosure.
A taxpayer must provide an adequate proof before the IRS and, ultimately, the Tax Court will agree that a portion of the proceeds from the foreclosure sale was in fact used to pay the taxpayer’s accrued interest.
Additionally, the taxpayer must not have been insolvent at the time of the interest payment for it to be considered “involuntary” and so ineligible for a deduction under the “interest first” criterion.
