Source: https://procedurallytaxing.com/tag/david-vendler/
Timestamp: 2019-04-19 08:47:43+00:00

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Anyway, following my bringing lawsuits against certain banks arising from their failure to properly report their customers’ interest payments, the American Bankers Association and the Mortgage Bankers Association requested the IRS to address the issue.
In late December 2016 the IRS responded that it would address the issue via its Industry Issue Resolution (“IIR”) program. This program, however, does not provide for public comment and I was afraid that the banks and the IRS would simply arrive at “guidance” that would conclude that section 6050H was ambiguous as to whether it required payments of capitalized interest to be reported. This way, even if the IRS concluded that I was correct about the reportability of the interest, the banks could then use the “guidance” announcing that there was an ambiguity to “prove” that they did nothing wrong in not previously reporting payments of capitalized interest.
In fact, however, there really is no ambiguity. The law is very clear and can be stated in a single paragraph. 21 U.S.C. section 6050H unambiguously requires banks and mortgage servicers to report on Form 1098 the “aggregate” of all mortgage interest they receive in a year (if that amount is over $600). The Supreme Court has held that “interest” unambiguously refers to money that has been charged for the use of money. Deputy v. DuPont, 308 U.S. 488 (1940). Case law further uniformly holds that payments of capitalized mortgage interest (whether in the loan modification context or the negative amortization loan context) are payments of mortgage interest that can be deducted in the year of payment. See Copeland v. C.I.R., T.C. Memo. 2014-226, (capitalized pre-loan modification interest held deductible as mortgage interest in the year of payment); Smoker v. C.I.R., 2013 WL 645265 *6 (Tax Ct. 2013) (same holding in the negative amortization loan context) [note Les discussed Copeland on PT here]. Since capitalization of interest does not change its character as interest (Motel Corporation v. Commissioner of Internal Revenue, 54 T.C. 1433, 1440 (1970)), payments of capitalized mortgage interest are part of the “aggregate” mortgage interest that banks and mortgage servicers “receive” and thus are required to be reported on Form 1098 by the plain and unambiguous language of section 6050H. Indeed, it was for this very same reason why 26 CFR § 1.6050S-3(b)(1) specifically requires that payments of capitalized student loan interest be reported on Form 1098-S. There is simply no logical distinction that can be made between the reportability of payments of capitalized student loan interest and capitalized mortgage interest.
After a bunch of submissions on my part to the IRS requesting to be included in the IIR process, the IRS has just last week declared that it is terminating the IIR process and will address the issue of the reportability of capitalized interest on Form 1098 by formal rulemaking. I see this as very good news insofar as the public, including you, will have an opportunity to comment. I further fully expect that whatever rule the IRS eventually publishes will be consistent with all of the law above since this was the conclusion the IRS reached on the reportability of student loan interest way back in 2004. That said, I expect that there will be heavy pressure from the banks and mortgage servicing entities to push for a rule that is “prospective-only” as was done with the student loan interest rule back in 2004. This will hurt consumers tremendously. Banks should instead be required to issue corrected Forms 1098 to all consumers which will (retrospectively) inform them of the interest that was not reported to them and allow them to file an amended return (if the statute of limitations has not expired) to recover his/her deduction. Further, if consumers are really to be helped, the IRS should include in its rule an exception to the statute of limitations (based on the fact that because of the bank’s misreporting, the consumer was unaware of the potential for amendment previously), or allow consumers to take the prior deductions in the current tax year. There simply is no justification for a prospective-only rule precisely because the question of the reportability of payments of capitalized interest has already answered. The mortgage industry just ignored that answer for the sake of reporting convenience.
Can a Receiver Take Advantage of the Claim of Right Provisions to Benefit Defrauded Consumers?
Section 1341 and the claim of right doctrine occupy an interesting place in tax procedure, essentially allowing the unwinding of a prior inclusion of income when later events demonstrate that the earlier income inclusion was unwarranted. While Les has written about Section 1341 in PT before (see his post on Joseph Nacchio and his efforts to use 1341 to generate a refund on funds forfeited following an insider trading guilty plea), this post discusses a different wrinkle on the issue, namely whether, and to what extent, a receiver appointed on behalf of a defrauded class of consumers can recover from the IRS under Section 1341 taxes that the wrongdoer paid to the IRS from funds obtained from the fraud. There are several thorny issues arising from this question currently pending in the First Circuit Court of Appeals in the case of Robb Evans & Associates, LLC v. US, First Circuit Case No. 15-2540, the resolution of which could have a wide impact on the ability of consumers, such as the victims of such scoundrels as Bernie Maidoff, to recover at least some of their losses from the IRS. (links here to the magistrate report and district court order on appeal).
Section 1341 codifies what is known as the “claim of right” doctrine and derives from equity. Very roughly, it provides that where a taxpayer reported income as being taxable in one year, but then has to repay that money in a future tax year, s/he can deduct in that later year the amount s/he paid back if that amount is over $3,000; alternatively if the deduction does not produce a tax savings equal to the tax imposed on the earlier inclusion, Section 1341 allows a taxpayer to essentially recompute the prior year’s tax and receive a credit based upon the lower tax that would have been imposed in the earlier year without including the proceeds. Courts have held that Section 1341 must be liberally construed to effectuate its underlying remedial purpose. Kappel v. U.S., 281 F.Supp. 426 (D.C.Pa. 1968) (liberal construction of Section 1341 is required because it is remedial in nature and its purpose is to avoid inequities).
The underlying facts in the Robb Evans case are that the original class action plaintiffs obtained a $250 million dollar judgment under the Credit Repair Organizations Act (“CROA”) 15 U.S.C. 1679, et seq. and other theories against Cambridge Credit Counseling Corp., two of its owners, and several of their related corporations. The judgment, which was upheld by the First Circuit in a separate appeal, provided for a constructive trust over all consumer funds and appointed an equity receiver (Robb Evans & Associates) to marshal all of the defendants’ available assets to satisfy the judgment. Because the judgment was largely uncollectable against the various defendants, the receiver brought an action against the IRS, alleging that under the “claim of right” doctrine, the IRS should be compelled to hand over to the receiver under Section 1341 the taxes that the defendants had paid to the IRS in the years in which they had been committing their fraud because those monies properly belonged to the defrauded consumers. The case primarily relied upon by the receiver was Cooper v. United States, 362 F. Supp. 2d 649 (W.D.N.C. 2005). In response to the receiver’s suit, the District Court entered judgment in favor of the receiver. However, the amount of the judgment was not for the roughly $13 million that the fraudsters had paid in taxes, but was limited to roughly $1.1 million, which was the amount that the receiver had already “actually restored” to the plaintiff class from other funds seized by the receiver. Both the U.S. and the receiver have appealed from this judgment.
Admittedly, Courts, on public policy grounds, consistently find that persons who receive income as a result of bad acts, and who later repay the money are not entitled to calculation under § 1341 See McKinney v. United States, 574 F.2d 1240 (5th Cir.1978) (same); Wood v. United States, 863 F.2d 417 (5th Cir.1989); see also Revenue Ruling, Rev. Rul. 68–153, 1968 WL 15327 (1968) (holding proceeds from embezzlement activity later repaid, the embezzler not permitted a refund calculated pursuant to I.R.C. § 1341). As such, the Court concedes that if the debtor in this case were the plaintiff seeking a refund, the I.R.S.’s denial of refund computation under § 1341 likely is warranted. In the least, Plaintiff’s summary judgment motion would not survive. However, the debtor is not the plaintiff. The plaintiff, here, is the creditor, represented by the trustee.
Imputing the bad acts of the debtor onto the bankruptcy trustee in the present case renders a categorically inequitable result, that is, the innocent victimized creditors get nothing, and the government gets a windfall.
The second issue raised is whether the “actual restoration” requirement, which has been read into Section 1341 by courts, but which appears nowhere in the actual language of the statute, should apply to an equity receiver. Basically, the “actual restoration” requirement holds that until the taxpayer actually relinquishes dominion of the funds he originally claimed as income, but which later events proved he was not entitled to retain, he cannot seek any refund from the IRS. The rationale for the “actual restoration” requirement is to prevent a taxpayer from receiving a refund from the IRS and then not actually restoring the funds to the person who it turned out had the superior right to them. In short, the requirement is there to prevent the taxpayer from simply keeping the money that is refunded by the IRS. But the receiver’s position is that since there is no danger that a court appointed receiver will keep the money that is refunded by the IRS, the “actual restoration” requirement does not make sense in this context. In fact, it only serves the inequitable purpose of preventing consumers from having their money restored to them by the court pursuant to a lawful judgment and creates a windfall for the IRS. Finally, while Treasury Regulation § 1.1341–1(e) does explicitly include the prior restoration requirement, the drafters of this regulation were clearly not contemplating receivership situations. The district court ultimately sided with the IRS on this issue concluding that Section 1341 implicitly contains the “actual restoration” requirement because the deduction must be “allowable,” and that other provisions of the tax code require taxpayers to make actual restoration before that condition can be met.
The third issue is that all prior Section 1341 cases involve cash basis taxpayers, whereas several of the defendants in the subject case were accrual based. The difference, of course, is that for an accrual basis taxpayer, it is the order to pay the funds back, which, at least from an accounting perspective, makes the deduction “allowable.” So why should actual restoration – which is a cash basis concept – apply to accrual basis taxpayers? The district court, however, sided with the IRS on this issue as well.
It is expected that the First Circuit will issue an opinion on the Robb Evans case sometime in early 2017.
The Supreme Court has unequivocally held that the word “interest” in tax statutes is unambiguous. It means “the amount which one has contracted to pay for the use of borrowed money.” Old Colony R. Co. v. Comm’r. of Internal Revenue, 284 U.S. 552, 560-561 (1932). See also Deputy v. du Pont, 308 U.S. 488, 497 (1940)). Section 6050H does not contain any exceptions, exclusions, or other type of qualifying language excluding particular kinds of “interest.” Indeed, Congress’s inclusion of the word “aggregate” in the language of the statute is clear evidence that all types of interest are to be totaled together at the end of the year and included in the recipient’s Form 1098 reporting.
Through the loan modification agreement, the $30,273 in past-due interest on petitioners’ mortgage loan was added to the principal [“capitalized”]. Because petitioners did not pay this interest during 2010 in cash or its equivalent, they cannot claim a deduction for it for 2010. They will be entitled to a deduction if and when they actually discharge this portion of their loan obligation in a future year”(emphasis added).
The principal of tax law that Copeland relies upon is not new. The Tax Court in Motel Corporation v. Comm. of Internal Revenue, 54 T.C. 1433 (1970) found in the context of late-paid interest that it retained its character as interest. As that court put it: “we can perceive no reason why defaulted interest should be transformed into principal for purposes of tax law.” In the context of a “negative amortization” pay option ARM loans, the Tax Court in Smoker v. C.I.R., 2013 WL 645265 (Tax Ct. 2013) also squarely held that deferred interest does not lose its character as mortgage interest simply because it is capitalized and added to principal; rather, capitalized interest is deductible in the year of payment.
Revenue Ruling 77-135, governing the treatment of deferred interest paid on “Graduated Payment Mortgages” (“GPMs”), also supports the position that capitalized mortgage interest does not lose its character as mortgage interest simply by being added to principal. GPMs are negative amortization loans like that which was at issue in Smoker, but instead of offering the customer an “option” to pay less than the interest due in any given month, they instead provide for a fixed schedule of payments which, in the early years of the mortgage, are for less than the interest actually due, but as the mortgage term continues, the payments “graduate” to recover the interest that was previously deferred. Revenue Ruling 77-135 explicitly holds that for cash basis taxpayers like the overwhelming majority of taxpayers, “…when the amount of the payments has increased to the extent that it now exceeds the current interest charge owed, the excess… will be treated as discharging first that part of the unpaid balance of the loan that represents accumulated interest carried over from prior years and will be included in income by the mortgagee and deducted by the mortgagor as interest at that time” (emphasis added).
We have argued that since there is already a revenue ruling applying the principle that capitalization of interest does not change its character as interest, and since section 6050H unambiguously requires that all types of interest be “aggregated” as part of the Form 1098 reporting calculation, there is no reason for the Service to provide any further “guidance” in response to the MBA’s and ABA’s “questions.” The answer is plain for all to see.
“Courts have defined the term ‘interest,’ for income tax purposes, as compensation paid for the use or forbearance of money. See, e.g., Deputy v. Du Pont, 308 U.S. 488 (1940). Consistent with this definition, the final regulations provide that capitalized interest is deductible as qualified education loan interest… Under the final regulations, a payment generally first applies to interest that has accrued and remains unpaid as of the date the payment is due and then applies to the outstanding principal.
See 69 FR 25489-02, 2004 WL 972762 *25490.
There is absolutely nothing to logically distinguish the reporting treatment of capitalized interest in the student loan context and the treatment of capitalized interest in the mortgage/loan modification context. Therefore, even if there was still some question of ambiguity remaining after Revenue Ruling 77-135 as to the treatment of capitalized interest, after 2004 no bank could reasonably claim that it needed further “guidance” on whether to report the payment of capitalized interest on an informational return.
The American Bankers Association’s letter repeatedly, and misleadingly, uses the term “new loan” with reference to loan modifications. It does so because where a borrower truly obtains a new loan, then all of the pre-existing interest is paid off and there is no question of reporting payments of pre-existing interest. But a loan modification is not a “new loan.” It is a modification of an existing loan. And, in a loan modification, pre-existing interest is not paid off, but is capitalized and thus cannot be made to simply “disappear” for the bank’s convenience.
[P]etitioners ask us to recharacterize their loan modification transaction. Instead of having modified the terms of their existing loan, petitioners say they should be treated as if they had obtained a new loan from a different lender and used the proceeds of that loan to pay both the principal of the Bank of America loan and the past-due interest… Contrary to petitioners’ “substance over form” argument, the transaction they hypothesize is not economically equivalent to the transaction in which they engaged… In any event, it is well established that taxpayers must accept the tax consequences of the transaction in which they actually engaged, even if alternative arrangements might have provided more desirable tax results.
The American Bankers Association (“ABA”) likewise should not be allowed to recharacterize the loan modification transactions in which its members “actually engaged” into “new loans.” Loan modification agreements all make very clear that the transaction is not intended to create a “new note,” but is intended to “amend” and/or “supplement” the original note. They also all require their borrowers to continue to comply with all of the requirements of the original notes except for the specifically modified provisions. But what really puts the lie to the ABA’s “new loan” claim is that the loan modification agreements themselves expressly declare that they are not to be so construed. For example, Bank of America’s loan modification form states that “Nothing in this agreement shall be understood or construed to be a satisfaction or release in whole or in part of the Note (referring to the original note) and Security Instrument (referring to the original deed of trust).” Bank of America also, notably, continues to use the same “old” loan number post modification and we are certain other lenders do as well. There is no way given the text of the loan modification agreements that any borrower would ever anticipate that banks would take the position that the agreements they signed were modifications in every respect except that they were entering into “new loans” for the purpose of pre-existing interest. Nor did any of the loan modification agreements advise borrowers that the banks would not be reporting this interest on Form 1098 and that they would effectively be giving up their mortgage deduction or, at the very least, forcing them to battle with the Service every year because their stated deductions would not match the Form 1098 issued by their lender.
A refinancing is a new transaction requiring a complete new set of disclosures. Whether a refinancing has occurred is determined by reference to whether the original obligation has been satisfied or extinguished and replaced by a new obligation, based on the parties’ contract and applicable law. The refinancing may involve the consolidation of several existing obligations, disbursement of new money to the consumer or on the consumer’s behalf, or the rescheduling of payments under an existing obligation. In any form, the new obligation must completely replace the prior one.” (Emphasis added).
Thus, while the ABA members could certainly have offered their borrowers in distress “new loans”, the fact is that they chose the entirely different route of loan modification and they did so for their own interest. Having done so, they should be made to live with that choice.
lender accepts a new note (emphasis added) in payment of remaining principal and interest due on an existing note,… it is incumbent on the individual to keep his own record of [his payments of the part of the new loan balance that is interest accrued on the original loan].
This is clearly the source of the ABA “new” loan language. But quoting a phrase does not necessarily make it fit; by its very terms, the Ruling applies only where “a lender accepts a new note in payment, i.e. in full satisfaction of the remaining principal and interest due on [an] existing note.” (Emphasis added). Indeed, the phrase “new note” as a restriction appears no fewer than 6 separate times in the text of the short Revenue Ruling.Since the ABA’s letter involves loan modifications and not “new notes,” Revenue Ruling 70-647 has no application to the loan modification issue presented by the ABA letter.
As can be seen from all of the above, there is overwhelming existing authority pointing to the conclusion that: (1) 26 U.S.C. Section 6050H unambiguously requires recipients of more than $600 in mortgage interest to report the “aggregate” amount of the interest they receive during the calendar year, i.e. the sum of all types of interest they receive; (2) capitalizing mortgage interest and adding it to principal does not change its character as mortgage interest such that, just as with student loans, payments of capitalized interest must be reported on Form 1098 when it is paid; and (3) loan modifications do not present any exception to this rule; they are not new loans, but are just what they purport to be: modifications of existing loans. Neither the ABA nor MBA letters offer any authority that would support an alternative view. We have argued therefore that there is thus no need for further “guidance” on what is a well-worn set of principles of tax law.
However, we have argued that if the IRS determines to issue some sort of “guidance,” it should not make it a “get out of jail free card” for the banks. While the banks would like a prospective-only guidance of the type issued back in 2004 with regard to how to treat capitalized student loan interest, there is absolutely no reason to do that in this case where the law has been clear (since at least that time) that capitalized interest is still interest and thus should be reported.
Taxpayers have suffered greatly because of what is at least incompetence, and more likely simply a decision that tracking such interest was too expensive to bother with for the banks. Indeed, the only reason the MBA and ABA are bothering with this issue now is because we caught its members doing it wrong. We are thus hopeful that the IRS will not simply aid the banks in the currently pending litigation by declaring an ambiguity in the law that it has itself said in 2004 does not exist.
Finally, we have argued to the IRS that whatever it decides to do, its action should do whatever it can to allow tax-payers to obtain the benefit of the billions of dollars in tax deductions that at least some of the ABA/MBA member banks have chosen (and “chosen” is a very deliberate word) to deny them out of their desire for expediency and cost reduction.
One of the most viewed posts last year was one that discussed a lawsuit alleging that Bank of America intentionally and systematically understated millions of dollars in homeowners’ mortgage interest payments following loan modifications. Today is the first of a two- part post by the lead lawyer on the case, David Vendler, a partner at Morris Polich & Purdy LLP. In this post, David updates us on developments in the case and related cases. In tomorrow’s post, David walks through in detail his legal arguments that underlie the claim that the bank has underreported interest.
We are writing to update your blog on the status of our case against Bank of America, N.A. involving its failing to include on Forms 1098 customer payments of deferred interest in the loan modification context. As your readers will recall, the question at the heart of the case is whether 26 U.S.C. 6050H requires banks and mortgage servicing companies to report on Forms 1098 borrower repayments of interest that were owed at the time of a loan modification and which have been are “wrapped into” the “new principal” of the loan post-modification.
An example was given in the earlier blog post that well illustrates the issue. Assume a homeowner facing financial distress has a $600,000 principal balance on a 15-year mortgage. At the time of the modification, the homeowner also owes $60,000 in delinquent interest. Post modification, the homeowner ends up with a 30-year mortgage and owes $660,000. That amount consists of the original principal plus the $60,000 in back interest. Our view is that the entirety of the borrowers’ post-modification payments should be applied first to retiring the $60,000 of pre-modification interest, and that those amounts should be reported on Form 1098. Bank of America and many other banks have taken the position that they are not going to report the repayment of this interest at all.
Last year, our case against Bank of America got thrown out by the district court (that dismissal is here). The ground for the district Court’s opinion was that the IRS supposedly has “exclusive enforcement” jurisdiction over 26 U.S.C. Section 6050H. We have appealed that ruling and briefing on that appeal will be complete next month. Argument will likely take place sometime in 2017. In the months since our case against Bank of America was thrown out, two other district courts in similar cases have explicitly refused to follow the Bank of America decision and have found these other Form 1098 cases “cognizable” in court; those opinions are found here and here. In our view, these subsequent decisions by two different federal judges bode well for our chances before the 9th Circuit. But there are also other movements afoot that will have ramifications on this issue (and our appeal) within this year.
Although the IRS refused all of our entreaties to become involved with this issue (made through the Office of the Taxpayer Advocate), two banking industry submissions – made pursuant to Rev. Proc. 2003-36 on September 15, 2015 and October 15, 2015 by the Mortgage Bankers Association (“MBA”) (MBA letter here) and American Bankers Association (“ABA”) (ABA letter here) – have apparently gotten the IRS to finally take notice. Specifically, on January 7, 2016, the IRS as part the IRS’ Industry Issue Resolution Program issued a curt statement stating it had agreed to accept two issues for consideration: (1) whether Section 6050H requires reporting of pre-loan-modification interest and (2) whether deferred interest in the negative amortization loan context should be reported.
Not surprisingly, neither the AMA’s and MBA’s letters claim that such interest should not be reported, but instead seek that the IRS issue a prospective-only rule that would (at least potentially) eliminate their members’ liability for having failed to report such interest in past years. We responded with our own submissions here in which we urged that the there is no need for “guidance” since there is a mountain of legal authority that already exists pointing inexorably to the conclusions: (1) that the payment of previously deferred mortgage interest must be reported on Form 1098 by the recipient of that interest in the year of actual payment and (2) that an intervening loan modification does nothing to change this.
We also pointed out that the only reason the ABA and MBA were seeking “guidance” is that some of its members are seeking to have the IRS help them avoid exposure in litigations like ours for their having improperly reported the mortgage interest payments of millions of Americans. Specifically, we stated that they are hoping to be able to create their own precedent so they can argue in Court that the IRS’s issuance of some sort of “prospective” “guidance” proves that an ambiguity existed in the law such that their under-reporting of interest was “reasonable.” However, we argued that the mere fact that some banks are reporting interest in a manner that is contrary to well-established law does not mean that there is an ambiguity in the reporting requirements. It just means that those banks are doing it wrong.
The real truth is that some ABA member banks (like Bank of America) chose expediency over compliance because tracking deferred interest is costly. But accuracy lies at the core of section 6050H. Clearly, any rule that promotes a schism between the amount of interest that a borrower pays to a lender from the amount of interest that lender reports on Form 1098 crosses purposes with the intent of section 6050H (this is not to say that the amount of interest deducted by the taxpayer will always match the amount of interest reported on Form 1098. For instance, a borrower might pay less than $600 in interest and thus not receive a Form 1098, but that borrower could still deduct the interest that he or she did pay). Because taxpayers, their tax preparers, and the IRS all routinely rely on the amounts contained on the lender-issued Form 1098, if pre-existing interest is not reported on Form 1098, most borrowers (and their tax preparers) would never even know: (1) there is a pre-existing interest balance that can be deducted, or (2) how to allocate their mortgage payments to determine in which tax-year they have repaid the prior interest balance. While this may be “good” for the treasury, it is inconsistent with the principle that everyone pays only the amount of tax they are required to pay under the tax code.
These problems all completely disappear if banks simply report the “aggregate” amount of interest (both current and pre-existing) that they actually receive as is mandated by the unambiguous language of § 6050H (recipients of “interest” on “any mortgage” are required to report on Form 1098 (to the IRS and to the payer) the “aggregate” amount of “interest” “received” during the calendar year if that amount “aggregates” to over $600). If that happens, then the taxpayer will deduct the proper amounts and the Form 1098 will have served its raison d’être by helping the IRS to verify that the amounts deducted are proper.
In tomorrow’s post we will discuss the legal issues underlying how banks are supposed to report interest.

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