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Misreporting by banks and mortgage servicing companies is costing U.S. taxpayers billions of dollars in mortgage deductions, according to two class-action attorneys who have represented clients in lawsuits against behemoths like Bank of America NA.
“Consumers are losing at least tens of billions, and perhaps hundreds of billions of dollars in tax deductions that the law clearly entitles them to take,” David J. Vendler, a partner at Morris Polich & Purdy LLP, and Michael R. Brown of Michael R. Brown APC wrote in a Nov. 22 letter to the Treasury Department released Dec. 6 under the Freedom of Information Act. The letter is incorrectly dated November 2015; Vendler confirmed it was sent this past November.
Several banks aren’t accurately reporting capitalized mortgage interest payments, Vendler told Bloomberg BNA Dec. 6. Capitalized mortgage interest arises when interest charged to a borrower isn’t paid at the time it’s due and becomes part of a modified mortgage’s principal. The payments should be reported on Form 1098, Mortgage Interest Statement, Vendler said. Without that reporting taxpayers aren’t aware that they’re entitled to a mortgage interest deduction, he said.
Vendler said that the requirement to report capitalized mortgage interest payments is clear under tax code Section 6050H. However, groups such as the American Bankers Association and the Mortgage Bankers Association have argued that the statute is ambiguous and the root of underreporting stems from a lack of clear IRS guidance.
Capitalized mortgage interest emerges in at least three different scenarios, Vendler said. The first of these is referred to as a “negative amortization loan” or “pay option adjustable-rate mortgage loan,” which allows a taxpayer to pay less in interest than is actually owed each month with the difference being tacked on to the mortgage principal. When the taxpayer pays off the principal plus “tacked-on” interest, the bank should report the interest payment, he said.
Loan modifications and short sales—when a bank agrees to let a borrower sell his or her home for less than the balance remaining on a mortgage and then use the proceeds to pay off that balance—can also give rise to underreported payments, Vendler said.
“There does not appear to be guidance under section 6050H addressing whether, when or how to report accrued but unpaid interest that becomes part of a loan upon modification,” the American Bankers Association said in an October 2015 letter, requesting that the issue be addressed in the Internal Revenue Service’s Industry Issue Resolution Program. “In the absence of guidance directly on point, lenders have adopted varying positions,” the letter said.
The ABA and MBA did not provide updated comments in response to Vendler and Brown’s letter. They referred Bloomberg BNA to the positions taken in their 2015 letters to the IRS and Treasury.
Vendler used the court case Horn v. Bank of America, N.A., in which he and Brown were lead attorneys, to illustrate the magnitude of this issue. In the case, filed by Morris Polich & Purdy LLP in 2012, the firm alleged that Bank of America failed to properly report Richard Horn’s payment of capitalized interest arising from a pay option loan.
The law firm eventually settled with Bank of America, and as part of the agreement the bank issued corrected Forms 1098 to affected customers. As a result of the settlement, approximately $2 billion in interest was reported on corrected forms, Vendler and Brown said in the November letter.
A Bank of America spokesman told Bloomberg BNA in a Dec. 7 e-mail that the company “reports capitalized interest on Pay Option ARMs in accordance with the settlement reached in the Richard Horn case.” Questions on the “industry’s perspective as to proper reporting” should be directed to the mortgage and banking associations, the MBA and ABA, he said.
Vendler disputed industry claims that Section 6050H is “ambiguous.” The statute says an “aggregate” amount of interest is to be reported, which means all types of interest, including capitalized mortgage interest, he said.
Michael Simkovic, an associate professor of law at Seton Hall University Law School, said Vendler and Brown’s policy arguments are “very convincing.” However, it’s not unequivocal that the use of the word “aggregate” is really a “slam dunk that makes it clear that the interest that has been capitalized is still interest,” he told Bloomberg BNA Dec. 16.
“I could see a tax lawyer or a compliance officer at a bank looking up that statute and not coming to that conclusion—not because they were trying to do anything slick or inappropriate, but because it’s hard to read the tax code,” said Simkovic. While he was an attorney at Davis Polk & Wardwell LLP, Simkovic assisted in the settlement of a multi-million dollar class-action related to mortgage lending.
It’s possible to come to a conclusion “that’s maybe not the best one,” especially if an attorney or compliance officer hasn’t “spent hours and hours researching the historical purpose of the statute,” he said.
Simkovic, who is transferring to the University of Southern California in the summer, said he’s hoping the IRS and Treasury will clarify the law by issuing new regulations.
In December 2015, the agency accepted requests to address the issue in its IIR program—Vendler and Brown’s letter incorrectly says December 2016; Vendler confirmed that date should be December 2015. Recently, the IRS terminated the IIR project and announced plans to proceed with formal rulemaking.
Vendler is wary of the impending guidance. He said if the agency issues regulations, they shouldn’t be prospective-only. “Such a rule will only hurt consumers by effectively denying them tax deductions to which they are undeniably entitled,” he said in the letter.
The American Bankers Association in 2015 expressed its support for prospective guidance. “Any reporting guidance should be applied on a prospective basis and applied only to loans that are modified after the effective date,” the group said. However, the association also asked that consideration be given to borrowers who may need to make changes in the interest deductions taken on previously filed tax returns “with a view to avoid significant levels of amended tax returns.”
It’s hard to estimate the number of taxpayers affected by this issue, “but we believe the number is substantial,” the group said. Figures reported by the Office of the Comptroller of the Currency suggest more than 6 million mortgages were modified between January 2008 and June 2015, the bankers’ association said. The most recent OCC report released in September says that servicers completed 34,604 modifications during the second quarter of 2016 alone.
To contact the reporter on this story: Allyson Versprille in Washington at email@example.com
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Text of the FOIA letter is at http://src.bna.com/kRj.Text of the 2015 MBA letter is at http://src.bna.com/kQR.Text of the 2015 ABA letter is at http://src.bna.com/kQI.Text of the IRS's memo to terminate IIR project is at http://src.bna.com/kQL.Text of the September 2016 OCC report is at http://src.bna.com/kQ6.
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