Taxing Lessons From Court Decisions

Decisions — Adjusting the interest

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When a CPA deducted interest on a rental mortgage, was he being reasonable?

In Wahlin (Docket #23108-16S), the taxpayer, a certified public accountant, owned three rentals. When he purchased them in 2005, he took out three adjustable rate notes with a bank. The notes provided for negative interest amortization. (Negative interest amortization means the monthly payments were less than the interest due under the notes and the bank would add the difference to the unpaid principal, increasing the principal from the initial borrowed amount.)

In 2009, the bank offered to modify the three loans and the taxpayer agreed. Under the new terms, the taxpayer was required to pay only interest for ten years. After ten years, the taxpayer would start making monthly payments to reduce the then-principal amount.

In 2013, the taxpayer sold the three properties in short sales. (A short sale is when a lender agrees to accept a mortgage payoff amount of less than what is owed so the property can be sold.) The taxpayer paid the sale proceeds to the bank to satisfy the three mortgages.

The bank issued a 2013 Form 1099-C, Cancellation of Debt, for each note and reported the remainder of the then-principal balance as the amount of debt discharged and zero as the amount of interest. The bank did not issue a 2013 Form 1098, Mortgage Interest Statement, to the taxpayer for any of the notes.

The taxpayer filed his 2013 federal income tax return on time and reported mortgage interest paid on each of the three rental properties, as well as properly reporting the cancellation of debt income.

The IRS disallowed the interest deduction and assessed an accuracy penalty.

The tax court agreed the IRS was correct in disallowing the interest deduction, saying that nothing in the record showed that the bank applied any of the proceeds to deferred or unpaid interest, and that the amounts listed as discharged debt equaled the then-unpaid principal amounts under the three notes reduced by the payments from the proceeds from the short sales. In addition, the court said, the bank did not issue Forms 1098, which it would have been required to do if any of the payments were applied to deferred or unpaid interest for 2013.

The taxpayer, a CPA with 44 years of experience, said that as a matter of accounting, the bank should have accounted for the deferred interest by applying a portion of the payments to the deferred interest on each note. The taxpayer also pointed to a district court case that was decided in January 2014, against the bank that held their mortgages. The bank was found to have incorrectly reported payments of deferred interest on adjustable rate mortgages.

The court said that class action lawsuit dealt with a settlement between a class of plaintiffs and the taxpayer was excluded from the suit. The court also said that the taxpayer’s unpaid deferred interest was converted into principal debt when the loans were modified in 2009. Under the modification, the original mortgages were extinguished and replaced by new, modified mortgages. Form 1098 reporting requirements only required the bank to report payments of interest that accrued on the loan after the modification.

The court then turned to the penalty assessed by the IRS. The taxpayer testified that he believed he had reasonable cause for deducting the interest, as he had relied on the court case that the bank had lost.

Do you think the court agreed with the taxpayer or the IRS on the penalty assessment?

Here is the reasonable cause exception for the penalty.

From internal revenue code section 6662(a): A penalty will not be imposed under this section if the taxpayer establishes he acted with reasonable cause and in good faith. Circumstances that indicate reasonable cause and good faith include reliance on the advice of a tax professional or an honest misunderstanding of the law that is reasonable in light of all facts and circumstances.

Relevant factors for the court to consider include the knowledge and experience of the taxpayer.



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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

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Right answer!

The taxpayer credibly testified that at the time he filed the 2013 tax return, the district court decision had been decided and that he believed that the basis of the settlement in that case would apply to his situation.

The court concludes that the taxpayer had reasonable cause for reporting the deferred interest as mortgage interest paid.

Therefore, the court concludes that the taxpayer is not liable for the accuracy-related penalty for 2013.

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