Caught In A (IRS Mortgage) Trap

Sometimes it seems that the tax Code is a trap waiting to spring on some unfortunate.  This time let’s talk about a trap involving mortgages.

(1) Chris and Jennifer bought a house in 2001 for $365,000.

(2) In 2003 they borrowed money ($427,333) from Jennifer’s mom. The note carried interest of 4.5%, and there was a document titled “Mortgage Note.”

(3) They also signed a second document titled “Mortgage.” This document included the following language:

“… hereby grant, convey and assign to … the property with the address of …..”

The document was signed, but it was not notarized or recorded at the courthouse.

(4) In 2008 Chris and Jennifer borrowed $200,000 from a bank. The bank required a note and mortgage. The bank recorded the mortgage.

(5) In 2009 Chris and Jennifer paid her mom $19,320 on her note and the bank $1,138 on theirs. They deducted the sum ($20,368) as mortgage interest on their tax return.

(7) The IRS audited their 2009 return.

What is there to look at?

The Code does not allow one to deduct personal interest. It used to, and people could deduct interest on their car loans and credit cards. That law changed in 1986, and the Code now restricts which types of interest are deductible.

One type is qualified residence interest. This is interest paid or accrued during the taxable year on acquisition indebtedness or home equity indebtedness secured by the qualified residence of the taxpayer. You and I call that a mortgage.

On first impression, it seems that Chris and Jennifer met this requirement.

Let’s look further at the definition of “acquisition indebtedness”:

(i)       In general – The term “acquisition indebtedness” means any indebtedness which –

(I)                Is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and

(II)             Is secured by such residence.

Regulation 1.163-10T(o) defines secured debt as “… recorded, where permitted, or is otherwise perfected in accordance with applicable State law.’

There is the trap. 

The debt has to be “perfected” under state law. The concept of “perfected” means that the secured creditor has a preferred position relative to an unsecured (or perhaps just a later) creditor. The money from that house goes to that mortgage holder, as he/she is first in line. Anyone else has to wait his/her turn.

Chris and Jennifer lived in Massachusetts, which requires a mortgage be recorded at the courthouse to be “perfected.”

Let’s start the unraveling:

(1) The mortgage was not perfected, meaning

(2) The debt to mom could not be “acquisition indebtedness,” meaning

(3) The interest on the debt could not be mortgage interest

The IRS – adding to its reputation of stabbing the dead – also charged Chris and Jennifer with the accuracy penalty. This is a “super” penalty and applies when the error trips certain dollar or percentage thresholds.

I cannot help but feel that the penalty was unnecessary. Is the IRS expecting people to be tax pros before they can fill-out their own tax returns? What are they going to do with me if I make a mistake on my return – shoot me?

I worry about this mortgage trap when working with intrafamily loans involving someone’s house. It can be tempting to cheat on attorney fees and not properly document or record the loan and mortgage.

If audited, one can expect the IRS to be as sympathetic to them as the IRS was to Chris and Jennifer.

Barriers to Tax Reform

The New York Times ran an article yesterday titled “The Real Barrier to Tax Reform” written by Bruce Bartlett. I have no issue with Mr. Bartlett, although I rarely read The New York Times. Nonetheless, what caught my eye is the following table of “tax expenditures”:

These “expenditures” make it difficult to raise enough “revenues” to cover whatever the government’s spending binge of the moment is.

I can see how reasonable people may debate the tenth – accelerated depreciation – as an expenditure. Instead look at categories such as the 401(k), medical insurance and employer-provided pension plans.

 A couple of observations on this:

(1)   Since when are monies taken from us as taxes to be called “revenues?”

(2)   Since when are monies we keep to be called “expenditures?”

There is an odor of bad fish with the vocabulary. Apple has revenues, as they have something I want and am willing to pay for. The government - not so much. This damage to the language is itself a barrier to tax reform.

Oh, you may be wondering about “exclusion of net imputed rental income.” Here is the concept: if you rented out your home rather than lived in it, someone would pay you rent. The government would then tax you on your rent. So, by living in your home rather than renting it out, you are costing the government money.

You, dear homeowner-living-in-your-home, are an “expenditure.”

Bruce Bartlett "The Real Barrier to Tax Reform"

What Does Insolvency Mean To The IRS?

Shepherd v Commissioner is a pro se case before the Tax Court. “Pro se” means that the taxpayer is representing himself/herself, without a professional. Technically that is not correct, as a taxpayer can go into Tax Court with a professional and still be considered “pro se.” This happens if the professional (say a CPA) has not passed the examination to practice before the Court. The CPA can then “advise” but not “practice,” and the taxpayer is considered “pro se.”

Today we will be talking about cancellation-of-debt income. Tax pros commonly refer to this is “COD” income. For many years I rarely saw a COD issue. In recent years it seems to be endemic. There are two common ways to generate COD: a home is foreclosed or a credit card is settled. If one pays less than the balance of the debt, the remaining balance is considered to be income to the debtor.

How can that be, you may ask. Let’s use an example. Say you go to your bank and borrow $50,000. When the loan is due, you cannot afford to pay in full. The bank agrees to accept $36,000 as full payment on the loan. From the IRS’ perspective, you received and kept a net $14,000. Perhaps you bought a car, went on vacation, or paid for a kid’s college, but you had an accession to wealth. The IRS considers the $14,000 to be income to you.

There are exceptions, and Shepherd involves the “insolvency” exception. This is different from the bankruptcy exception. Granted, in both cases you are likely insolvent, but for the insolvency exception you do not have to file with a bankruptcy court.

Let’s quickly take a look at the wording for insolvency in the tax code:

   108(d)(3) INSOLVENT.— For purposes of this section, the term “insolvent” means the excess of    liabilities over the fair market value of assets. With respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer's assets and liabilities immediately before the discharge.

An easy way to understand insolvency is the following formula:

·        Add the fair market value of everything you own, then

·        Subtract everything you owe

If the result is negative, you are insolvent. You owe more than you own. You are negative or upside-down. There are special rules for assets such as a pension, but you get the concept.

The IRS says that – if you are insolvent – then COD income not be taxable to you to the extent you are insolvent. Let’s use numbers to help understand this:

·        You own $160,000

·        You owe $175,000

·        Visa forgives $22,000

Your COD income is $22,000 (what Visa forgave).

Your insolvency is $15,000 (175,000 – 160,000).

Therefore $7,000 of your COD income (22,000- 15,000) will be taxable to you. The rest is not taxable.

The tax law requires you to do the calculation of what you own and what you owe as of the date the debt is forgiven. It is not two years later or 18 months before. Remember: this is tax law not a tax suggestion.

Let’s swing over to Shepherd. He and his wife lived in New Jersey and owed Capital One Bank approximately $10,000. In 2008 they settled for approximately $5,500, leaving COD income of $4,500.

The Shepherds claimed insolvency and did not report the $4,500 as 2008 income. The IRS looked into it and found that the key to the insolvency calculation was the value Shepherd attached to two houses.

The first was his beach house. Shepherd received a property assessment of $380,000 for the 2010 tax year. He appealed the assessment, claiming a value closer to $340,000. He presented this as evidence before the Court. The Court had two immediate issues:

·        There is a long-standing tax doctrine that the value of property for local tax purposes is not determinative of fair market value for federal income tax purposes. This is the Gilmartin case, and it clearly established the tax code’s preference for an appraisal over property tax bills.

·        Shepherd did not present to the Court the methodology, procedures or analysis, including comparable sales, for thinking that the value was closer to $340,000. At that point it was just an opinion, and the Court was not bound by his opinion.

The Court pointed out that these events took place two years after the debt forgiveness and said fuhgeddaboudit to Shepherd’s valuation of the beach house.

The second was his principal residence.

·        Shepherd showed the Court a tax bill. The Court duly dismissed that under the Gilmartin doctrine.

·        Shepherd applied for a loan modification in 2011. Chase Home Finance showed a value of $380,000 in a modification letter. The Court wasn’t buying into this, noting that Chase’s letter did not show any analysis or procedures used in arriving at value, such as comparable sales. That is, it was not an appraisal. Oh, and by the way, the letter was three years after the debt discharge.

What is a tax pro’s take? Folks, Shepherd had virtually no leg to stand on. How can one read the tax code stating “immediately before the discharge” and reason that three years later – and after one of the worst housing markets in U.S. history – would constitute “immediately before”? This is simply not reasonable. You are going to lose this if challenged by the IRS. Shepherd’s position is so preposterous that I suspect he was truly “pro se” and did not have a professional, either when he prepared his return or when he was presenting his arguments in Court.

Mortgage Debt Forgiveness

We saw a home foreclosure reported this tax season.

You may remember that the Mortgage Relief Act allows taxpayers to exclude up to $2 million of mortgage debt forgiveness on their principal residence. This is an exception that the general rule that includes cancelled debt in income. The term of art is “qualified principal residence debt.” The key part here is “principal residence.” You can have several homes, but only one home can be your principal residence. A principal residence can be a house, a condominium, a cooperative, a mobile home or houseboat. I remember a fellow who docks his yacht off the coast of Jacksonville. I suppose he could consider his yacht his principal residence, if he and his wife lived there enough. It wouldn't be a bad life, as the yacht was around 100 feet long and had a professional crew. He was, needless to say, quite well-off.

Here is what doesn’t qualify: a vacation home, a second home, a business property or a rental property.

The debt itself must have been incurred to buy, construct or substantially improve that principal residence. Herein lays a possible trap. Say that you refinanced your house for $250,000 when its original mortgage was $180,000. You used the additional monies to … well, who knows what you did, but you did not fix-up the house. Maybe you sent a kid to college. If the house gets foreclosed and that debt cancelled, you may have a problem. Let’s say the debt is $250,000, to keep the discussion easy. Only $180,000 of that debt will qualify, as only $180,000 represents the purchase, construction or improvement (or refinancing of the same) of the principal residence. The remaining $70,000 ($250,000 – 180,000) represents income from cancelled debt. It may be that the $70,000 may be excludable under another provision (say insolvency), but it will not be excluded under the Mortgage Relief Act.

What I see as an unfortunate fact pattern is a saver who paid off, or paid down, his/her house and then runs up a second mortgage for unexpected debt, such as medical bills or unemployment. You can see that this mortgage would not have been incurred for the purchase, construction or improvement (or refinancing of the same) of a principal residence. There would be no relief for this person, at least under the Mortgage Relief Act.