The Tax Court had to look at a taxpayer’s attempt to claim a deduction for interest paid on a home equity credit line by the application of funds when the property was foreclosed in the case of Howland v. Commissioner, TC Memo 2022-60.[1]  And the Tax Court found that the answer isn’t quite as clear as you might expect at first glance.

Facts of the Taxpayer’s Case

This case revolves around a taxpayer who had two loans secured by his residence that ended up in foreclosure.  A first mortgage was held by Bank of New York Mellon, as successor in interest to Countrywide Home Loans while a second mortgage was held by CenterState Bank.  The total amounts outstanding on the loans at the time of the foreclosure for the principal, interest and fees on both loans was $624,106.

The opinion describes the case as follows:

In June 2014 First Southern Bank merged with CenterState Bank. Since petitioners had not made any payments on the Haven Trust Bank credit agreement, First Southern Bank filed a verified complaint for foreclosure (foreclosure complaint) in the Seventh Judicial Circuit Court for St. Johns County, Florida (circuit court). When the foreclosure complaint was filed, petitioners owed $377,060 in principal on the credit agreement, plus accrued interest, fees, and other charges. In the foreclosure action First Southern Bank sought an award from the circuit court for the full amount due from petitioners, including the right to foreclose on petitioners’ residence based on the granted credit agreement.

As part of the foreclosure complaint, the circuit court entered a summary final judgment, resulting in a foreclosure sale of petitioners’ residence on July 28, 2016. CenterState Bank was the highest bidder at the foreclosure sale and acquired the residence with a bid of $321,000. At the time of the foreclosure sale, the sum of the accrued interest on the credit agreement was $100,607.

On June 9, 2016, a second foreclosure complaint regarding petitioners’ residence was filed in the circuit court by the first mortgage holder, Bank of New York Mellon, as successor in interest to Countrywide Home Loans. Bank of New York Mellon claimed a balance due of principal, interest, late charges, attorney’s fees, and other permitted expenses of $247,046.

On December 30, 2016, CenterState Bank sold petitioners’ residence to third parties for $594,000. No Internal Revenue Service (IRS) Form 1098, Mortgage Interest Statement, was issued to petitioners for tax year 2016 for the home mortgage interest in question. There is no evidence in the record as to how the sale proceeds of $594,000 were applied to petitioners’ debts with First Southern Bank and Bank of New York Mellon.[2]

The taxpayers claimed over $100,000 of mortgage interest deductions for the year of the foreclosures, a year in which the only payment on the notes came from the foreclosure transactions.

Tax Court Analysis

The Court’s summary of the positions of the parties reads as follows:

Petitioners argue that the foreclosure of their mortgage constituted a taxable sale or exchange. Next, petitioners contend the fair market value of the residence is equal to the price that a willing buyer paid shortly after the foreclosure. On the basis of the terms of the credit agreement, petitioners contend the amount CenterState Bank received in the foreclosure proceedings and specifically in the subsequent sale to a third party should be applied first to their outstanding interest owed, and then to principal. …

On the other hand, respondent argues that petitioners are not entitled to the home mortgage interest deduction claimed on their 2016 Form 1040. According to respondent, the foreclosure bid did not cover the principal balance due from petitioners to CenterState Bank, after payment of the first mortgage balance due to Countrywide Home Loans. Accordingly, no interest amount was paid to CenterState Bank at the time of the foreclosure sale.[3]

There is no question that if the interest in question was paid, it was otherwise home mortgage interest deductible on Schedule A.  But the key question was if interest had actually been paid on the second mortgage.

The Tax Court summarized the general rule for applying payments on the mortgage, as well as the impact of a foreclosure:

The general rule in this area is that voluntary partial payments made by a debtor to a creditor are, in the absence of any agreement between the parties, to be applied first to interest and then to principal. See Lackey v. Commissioner, T.C. Memo. 1977-213, 36 T.C.M (CCH) 890. However, an exception to this general rule exists in the case of an involuntary foreclosure of mortgaged property where the evidence “strongly indicates” that the mortgagor is insolvent at the time of foreclosure. See Newhouse v. Commissioner, 59 T.C. 783, 789 (1973).

Rejecting the interest first rule, we held in Newhouse and Lackey that no portion of the proceeds from either of the foreclosure sales therein was allocable to interest since the debtors were insolvent. While in Estate of Bowen v. Commissioner, 2 T.C. 1 (1943), we applied the proceeds from a foreclosure sale to interest first and then to principal where the debtor was not shown to be insolvent and the payments, in spite of foreclosure, were said to be voluntary.[4]

But the court notes that this situation is not exactly like any of the prior cases:

In this case the payments were not voluntary; however, there is no evidence petitioners were insolvent at the time of the foreclosure. Furthermore, unlike Lackey and Newhouse, this case involves a clear written agreement — namely the credit agreement — between the lender and petitioners that repayments on the note are applied first to interest. Consequently, we find our decisions in Lackey and Newhouse to be distinguishable.[5]

The court notes that the IRS argued that since, once the obligation to the first mortgage holder was satisfied, there wasn’t enough funds left to pay off the second mortgage’s principal balance, that meant none of the payment would count as interest expense:

The core dispute in these cases relates to the application of the proceeds from the foreclosure sale of petitioners' home. Respondent does not dispute that the amount realized under the foreclosure proceeding by CenterState was $594,000; rather, respondent contends that petitioners ignore the property's first mortgage of $247,046, resulting in a net difference of $346,954 — which is less than the principal balance of $377,060 due to CenterState, and consequently petitioners paid no interest.

We agree, in part, with respondent's argument. While respondent is correct that CenterState did not realize the full $594,000, but rather received only $346,954 after the first mortgage was satisfied, we cannot definitively conclude that CenterState received only the payment of principal from petitioners.[6]

The Court outlines how it plans to analyze the matter:

It is undisputed that the principal balance due to CenterState was $377,060; however — as petitioners argued — under the terms of the credit agreement, delinquent payments were to be first applied to interest due from petitioners, rather than to principal. Therefore, we must analyze the terms of the foreclosure action and its tax implications here.

Per the judgment issued by the circuit court, the total amounts due included principal of $377,060, interest computed to March 8, 2016, of $65,482, appraisal fees of $650, and deferred interest of $26,139. These four amounts total $469,331. At the time of the foreclosure sale, the sum of the accrued and deferred interest on the credit agreement equaled $100,607. Petitioners contend that CenterState, as successor in interest and holder of the promissory note, was contractually bound to apply the foreclosure proceeds first to interest and second to principal. Respondent, however, argues that these payment provisions found in the promissory note are not applicable here in the context of a foreclosure sale.[7]

While the analysis seems like it may come out in the taxpayers’ favor, the Court eventually found that the taxpayer failed to carry the burden of proof:

The record before us is silent as to how CenterState applied the funds received and whether petitioners owe any remaining principal balance. These facts (if favorable) could support a finding that petitioners in fact paid home mortgage interest (in some amount) — rather than repaying principal balance. However, statements in briefs do not constitute evidence. Rule 143©; Evans v. Commissioner, 48 T.C. 704, 709 (1967), aff’d per curiam, 413 F.2d 1047 (9th Cir. 1969); Chapman v. Commissioner, T.C. Memo. 1997-147; Berglund v. Commissioner, T.C. Memo. 1995-536. Pertinent facts missing from the stipulation merely mean that the party bearing the burden of proof has failed to sustain the burden of showing them. See Evans, 48 T.C. at 709.

Petitioners bear the burden of proof and must show, by a preponderance of the evidence, that they are entitled to a home mortgage interest deduction of $103,498, or some other amount. For the reasons discussed above, we conclude that petitioners have failed to meet their burden. Accordingly, we will sustain respondent’s determination to disallow this deduction claimed by petitioners.[8]

The Court makes it clear that a deduction is possible in a case like this—but the taxpayer must show more than this taxpayer showed.

[1] Howland v. Commissioner, TC Memo 2022-60, June 13, 2022, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/home-mortgage-interest-deduction-denied-after-foreclosure/7dkn3 (retrieved June 14, 2022)

[2] Howland v. Commissioner, TC Memo 2022-60, June 13, 2022

[3] Howland v. Commissioner, TC Memo 2022-60, June 13, 2022

[4] Howland v. Commissioner, TC Memo 2022-60, June 13, 2022

[5] Howland v. Commissioner, TC Memo 2022-60, June 13, 2022

[6] Howland v. Commissioner, TC Memo 2022-60, June 13, 2022

[7] Howland v. Commissioner, TC Memo 2022-60, June 13, 2022

[8] Howland v. Commissioner, TC Memo 2022-60, June 13, 2022