Milkovich v. United States
| Decision Date | 02 March 2022 |
| Docket Number | No. 19-35582,19-35582 |
| Citation | 28 F.4th 1 |
| Parties | Lisa MILKOVICH; Dang Nguyen, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee. |
| Court | U.S. Court of Appeals — Ninth Circuit |
Kenneth C. Weil (argued), Law Office of Kenneth C. Weil, Seattle, Washington, for Plaintiffs-Appellants.
Rachel Ida Wollitzer (argued) and Joan I. Oppenheimer, Attorneys, Tax Division/Appellate Section; Richard E. Zuckerman, Principal Deputy Assistant Attorney General; United States Department of Justice, Washington, D.C.
Before: Jay S. Bybee and Daniel P. Collins, Circuit Judges, and Richard G. Stearns,** District Judge.
Plaintiffs Lisa Milkovich and her husband Dang Nguyen appeal from the district court's dismissal of their complaint seeking a refund of additional taxes they paid after the Internal Revenue Service ("IRS") disallowed the deduction they had claimed for the mortgage interest that their lender received at the short sale of their home. Concluding that, on the facts as pleaded, Plaintiffs were entitled to the deduction, we reverse.
In 2005, Plaintiffs purchased a home in Renton, Washington for $748,425, and they took out a mortgage in connection with that purchase.1 The complaint does not disclose the original value of that mortgage, but a year later Plaintiffs refinanced that loan. The new mortgage had a principal amount of $744,993, and the mortgage was ultimately held by CitiMortgage. Several years later, Plaintiffs became unable to continue making their monthly payments of $3,724.94, and they made their last such monthly payment in February 2009.
Plaintiffs jointly filed for Chapter 7 bankruptcy in January 2010. In the schedules filed with their bankruptcy petition, Plaintiffs reported that their home had an approximate current value of $600,000. Because the value of Plaintiffs' home was well below the amount of CitiMortgage's secured lien, the home had no value to creditors in the bankruptcy estate. Indeed, after examining Plaintiffs' financial affairs, the bankruptcy trustee promptly reported to the bankruptcy court that "there is no property available for distribution from the estate over and above that exempted by law" and that he was abandoning the assets of the estate with no distribution to creditors. As a result, Plaintiffs retained legal title to their home after the trustee's abandonment. See Mason v. Commissioner , 646 F.2d 1309, 1310 (9th Cir. 1980) ().
In April 2010, Plaintiffs received a discharge from the bankruptcy court. The parties agree that this discharge changed Plaintiffs' mortgage from "recourse" to "nonrecourse"—that is, it eliminated the pre-existing ability of CitiMortgage to enforce the mortgage debt personally against Plaintiffs and instead limited CitiMortgage to enforcing only the value of its lien. See Johnson v. Home State Bank , 501 U.S. 78, 84, 111 S.Ct. 2150, 115 L.Ed.2d 66 (1991) (). Plaintiffs were thus relieved of personal liability on the mortgage debt, but the loan owed to CitiMortgage continued to be secured by the property and Plaintiffs' payment schedule (if they wished to avoid foreclosure) was unaffected by the discharge. See Dewsnup v. Timm , 502 U.S. 410, 417, 112 S.Ct. 773, 116 L.Ed.2d 903 (1992) (); see also Johnson , 501 U.S. at 83, 111 S.Ct. 2150 ().
Rather than foreclose on the property, CitiMortgage eventually agreed to a "short sale," which took place in July 2011. "A short sale is a real estate transaction in which the property serving as collateral for a mortgage is sold for less than the outstanding balance on the secured loan, and the mortgage lender agrees to discount the loan balance because of a consumer's economic distress." Shaw v. Experian Info. Sols., Inc. , 891 F.3d 749, 752 (9th Cir. 2018). The sale price of the residence at the short sale was approximately $555,005.92, of which about $522,015 was paid to CitiMortgage in satisfaction of the loan. CitiMortgage credited $114,688 toward the accumulated unpaid interest on the secured loan, while the remaining amount was credited toward paying off the loan principal. CitiMortgage then issued a Form 1098-Mortgage Interest Statement ("Form 1098-MIS") for 2011 indicating that it had received $114,688 in interest payments from Plaintiffs. Based on that statement, Plaintiffs claimed a $114,688 mortgage interest deduction that year.
In October 2014, the IRS issued a notice of deficiency, stating that the IRS intended to disallow the $114,688 interest deduction on the ground that Plaintiffs "did not establish that the amount ... was (a) interest expense, and (b) paid." Because, however, the IRS mailed the notice to the Renton home that Plaintiffs had sold at the 2011 short sale, Plaintiffs never received or responded to it. Given Plaintiffs' lack of response, the IRS disallowed the interest deduction and assessed additional tax due.
After Plaintiffs later learned of the IRS's action, they pursued various administrative remedies, but in May 2018, the IRS Appeals Office denied Plaintiffs' requests for relief. In doing so, the IRS explained that Plaintiffs had "realized income from cancellation of debt of $222,977.95" at the short sale, but that Plaintiffs "were not required to recognize that income because it was non-recourse debt." "[B]ecause [Plaintiffs] have unrecognized income from forgiveness of debt in excess of the accrued interest," the IRS stated, they "have no loss of income from that interest." The IRS therefore concluded that the interest deduction was properly disallowed under I.R.C. § 265(a)(1), which precludes deductions that are "allocable to one or more classes of income ... wholly exempt from the taxes imposed by this subtitle." That limitation on deductions applied here, according to the IRS, because the asserted cancellation-of-debt income that occurred at the short sale was exempt from income taxes "due to being non-recourse."
Plaintiffs paid the tax assessed and filed a claim for a refund with the IRS. After the IRS did not respond within six months, Plaintiffs filed this civil action seeking a refund under 28 U.S.C. § 1346(a)(1) and 26 U.S.C. §§ 6532(a)(1), 7422(a). The district court, however, granted the IRS's motion to dismiss Plaintiffs' complaint pursuant to Federal Rule of Civil Procedure 12(b)(6).
In dismissing the action, the district court did not rely on the § 265 -based rationale that the IRS had invoked in its earlier response to Plaintiffs. Instead, the court reasoned that, although "interest deductions are generally allowed," Plaintiffs' interest payments fell under an exception established in Estate of Franklin v. Commissioner , 544 F.2d 1045, 1048–49 (9th Cir. 1976), for interest claimed in connection with purportedly debt-financed transactions that lacked economic substance. Although Plaintiffs were unlike the taxpayers in Estate of Franklin —who had acquired their debt liability in a transaction that lacked economic substance—the district court extended Estate of Franklin to cover validly issued mortgages that later resulted in short sales in which "the nonrecourse liability (here, the mortgage) exceeds a reasonable estimate of the fair market value of the indebted property." Because the fair market value of Plaintiffs' property had declined to well below the mortgage balance, the district court concluded that the "transaction" lacked economic substance and that therefore any interest deduction relating to that transaction was barred.
Plaintiffs timely appealed the district court's judgment. We have jurisdiction pursuant to 28 U.S.C. § 1291, and we review the motion to dismiss de novo. Wells Fargo Bank, N.A. v. Mahogany Meadows Ave. Tr. , 979 F.3d 1209, 1213 (9th Cir. 2020).
We hold that, on the facts as pleaded, Plaintiffs are entitled to deduct the mortgage interest paid in connection with the short sale of their home in 2011.
As noted earlier, the district court rested its dismissal on the view that, under Estate of Franklin , Plaintiffs' underwater nonrecourse mortgage did not constitute a genuine indebtedness that could support a mortgage interest deduction. We conclude that the district court erred in extending the principles of Estate of Franklin to short sales involving mortgages that were valid ab initio.
In Estate of Franklin , we concluded that a partnership's purported debt-financed "purchase" of a motel and related property lacked economic substance and therefore did not give rise either to genuine indebtedness that would be "able to support an interest deduction" or to an "investment in the property" that would support deductions for depreciation. 544 F.2d at 1049 (emphasis omitted). In reaching this conclusion, we relied on a number of features of the relevant transaction. In particular, we noted that the property was purchased at an apparently inflated price that exceeded "a demonstrably reasonable estimate of the fair market value." Id. at 1048. Moreover, although $75,000 in "prepaid interest" was paid up front by the partnership, thereafter the partnership effectively did not have to make any further payments for 10 years: although principal and interest payments were due each month, those payments were set at an amount that closely approximated the monthly lease payments due from the "seller," who retained possession of...
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