Under Reporting the Mortgage Interest Deduction?

Bank of America has asked a Federal judge to dismiss a nationwide class action lawsuit. Bank of America is accused of intentionally and fraudulently under reporting interest collected by the bank on the Form 1098 Mortgage Interest Statement. The suit was brought under IRC §7434 which provides for civil damages for fraudulent filing of information returns. The lawsuit is centered on homeowners who fell behind on mortgage payments owing both principle and interest and then received a modified loan from Bank of America. The modifications basically added the interest to the balance of the mortgage principle.

To illustrate, assume a homeowner facing foreclosure has mortgage principle of $300,000on a 15 year mortgage issued by Bank of America. At the time the modification is initiated the homeowner may owe $15,000 in delinquent interest. After the modification, the homeowner has a 30 year mortgage and owes Bank of America $315,000 consisting of the original principle amount of $300,000 plus the $15,000 in back interest.

The homeowner is not permitted to take the $15,000 interest as a mortgage interest deduction at the time the loan is modified. The courts have upheld the IRS disallowance of the interest deduction for back interest due in the year of modification.  This is consistent with IRS and IRC rules and regulation permitting deduction only when the cash has been paid by a cash basis taxpayer.

When the homeowner pays the delinquent interest over the course of the modified loan, the delinquent interest plus the interest paid on the modified $300,000 mortgage give rise to a home mortgage deduction under §163 in each year of payment.  Here is the crux of the suit, since the homeowner may not deduct the delinquent interest until it is paid in future years and Bank of America failed to include the delinquent interest in subsequent Form 1098s to its borrowers, the borrowers have overpaid on their taxes because the mortgage deduction reported was under reported on the Form 1098. Because of IRS regulations limiting the time an amended return may be filed many homeowners will not be able recover the taxes paid.

There are additional elements to the lawsuit; a claim by the borrower’s attorneys that Bank of America knowing the practice was wrong but intentionally under reported the interest to minimize its reporting of income. Interest is deductible to the taxpayer paying and income to the taxpayer collecting the payment. Principle is not deductible or reportable as income. Counter claims by the bank the plaintiffs are seeking to make the bank their tax preparer as no statue or rule requires lenders to track payments of interest that has become part of the loan’s principle balance.

Given the number of home mortgage modifications following the 2008 and 2009 housing debacle the potential exists that many or all lenders have followed the same practice as Bank of America. There is no information as yet on what if anything homeowners can or should do to determine if they have overpaid taxes as a result of Bank of America’s and other lenders conduct.

I recommend homeowners with loan modifications consult with their tax advisor on how to best handle the potential tax consequences of a lender’s treatment of the delinquent interest under a loan modification.

Article link 1 Thomas Rueters article covering the classaction suit.

Article Link 2 Procedurly Taxing blog post discussing the legal and tax implications of the suit.

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