The following is the first part of a two-part post addressing lawsuits relating to allegedly erroneous information returns Bank of America issued; today’s post relates to the issuance of Form 1098 (mortgage interest) and tomorrow’s relates to 1099C (cancellation of debt income). An earlier version of the posts appeared on the Forbes PT site on January 6, 2015.
A couple of developments from late last year involving Bank of America and its issuance of supposedly erroneous information returns are worth highlighting. One relates to Bank of America’s mortgage interest reporting on Form 1098 and the other relates to its issuance of Form 1099C addressing cancellation of debt. Both cases implicate federal and state law causes of action to remedy what the plaintiffs allege to be fraudulent or at a minimum negligent conduct by Bank of America. The plaintiffs in both cases elicit sympathy and as we move into the information return issuance season, the cases should give even greater incentive to take care in issuing tax forms that may provide a pathway to unanticipated liability.
In today’s post, I will discuss the case of Smith et al. v Bank of America, which addresses supposedly incorrect 1098s that, according to the complaint, stemmed from Bank of America intentionally and systematically understating millions of dollars in homeowners’ mortgage interest payments. Tomorrow I will talk about the case of Raley v Bank of America, where Freddie Raley, a disabled veteran, sued Bank of America after receiving what he claimed to be an incorrect Form 1099C showing cancellation of debt income stemming from credit card accounts he claimed to have not opened. Both cases feature plaintiffs’ use of state law causes of action to attempt to hold the financial giant liable for its actions and highlight the limitations of Section 7434, which allows private parties to sue issuers of certain fraudulently issued information returns.
Smith et al. v Bank of America
First, I want to focus on the 1098 mortgage issue and the case of Smith et al. v Bank of America (BOA) from the Central District of California. (Case Number 2:14-cv-06668-DSF-PLA). Last week, Reuters reported that plaintiffs have been seeking class certification relating to the bank’s alleged underreporting of mortgage interest.
The facts in the case are reminiscent of the Copeland v Commissioner Tax Court case I wrote about late last year in Living With Your Decisions: Delinquent Mortgage Debt. The BOA lawsuit essentially involves homeowners who fell behind on mortgages (both principal and interest) and then received a modified loan from BOA for the delinquent interest balance plus the principal. The modified loan often changed key aspects of the original debt, including the length of the loan and interest rate.
A simplified example taken from the BOA complaint may help illustrate. Assume a homeowner facing financial distress has a $600,000 principal balance on a 15 year mortgage issued by BOA. At the time of the modification, the homeowner may also owe $60,000 in delinquent interest. After the modification, the homeowner has a 30 year mortgage and owes BOA $660,000. That amount consists of the original principal plus the $60,000 in back interest.
In Copeland v Commissioner, using this example, the taxpayer sought to get the $60,000 deduction at the time of the modification. As I discussed in my post, the IRS properly disallowed the interest deduction for the back due interest in the year of the modification. As the court explained,
[t]hrough the loan modification agreement, the…past-due interest on petitioners’ mortgage loan was added to the principal. No money changed hands; petitioners simply promised to pay the past-due interest, along with the rest of the principal, at a later date. Because petitioners did not pay this interest during 2010 in cash or its equivalent, they cannot claim a deduction for it for 2010. They will be entitled to a deduction if and when they actually discharge this portion of their loan obligation in a future year.
Unlike Copeland, the homeowners in Smith did not deduct the delinquent interest at the time of the modification. The BOA lawsuit thus is about the payment of the past due interest in the future years, and BOA’s failure to include that amount in subsequent Form 1098s to its borrowers. When the taxpayer subsequently pays the amount of back due interest over the period of the modified loan, that amount should (plus the interest paid on the modified $660,000 debt) give rise to a deduction under Section 163 in each year of payment.
In the BOA case, the bank failed to report on the Form 1098 the amounts that were in respect of the delinquent interest that was rolled into the modified loan. The following summary of the facts is from the bank’s memorandum in support of its motion to dismiss the complaint:
Plaintiffs Lora Smith and Cynthia Himple borrowed money from predecessors of Defendant Bank of America, N.A. (“BANA”) to buy their homes. After Plaintiffs fell behind in their loan payments, BANA – rather than foreclose on their homes – agreed to modify their loans. When it did so, any accrued interest that Plaintiffs had not paid or had contractually deferred paying was added to their modified loans’ principal balances.
In subsequent years, Plaintiffs made payments on their modified loans that reduced their loans’ principal balances. Plaintiffs allege that these payments were interest payments, asserting that the payments reduced the portion of their loan principal balances attributable to the previously unpaid or deferred interest. Plaintiffs therefore allege that, under 26 U.S.C. § 6050H, BANA should have reported those payments as “interest received” on Internal Revenue Service (“IRS”) Form 1098 (Mortgage Interest Statement). Form 1098 is an IRS information return, which BANA files with the IRS to assist the IRS with checking the accuracy of claimed mortgage interest deductions. Because BANA did not report those payments on Form 1098, Plaintiffs suggest that they claimed a smaller mortgage interest deduction than they should have claimed, thereby overpaying their taxes.
In other words, in later years the bank only reported on 1098 the amount of interest paid on the modified loan, rather than that amount plus any portion of the payments on the modified loan that satisfied the deferred interest rolled into the modified loan. Those actions, according to the complaint meant that Bank of America was “systematically, knowingly and intentionally underreporting on Forms 1098 hundreds of millions if not billions” in interest.
The original complaint raises state law claims of breach of contract, fraud, breach of implied covenant and a violation of California’s Unfair Business Practice Act. It also seeks a judgment ordering the court to correct BOA’s reporting practice prospectively. The complaint also alleges that the bank a violated Section 6050H (requiring the reporting of interest over $600 paid on a mortgage).
The complaint also alleges that BOA knew that its practice was wrong but that it did so to minimize its reporting of income (interest is income, principal is not) and to minimize its compliance costs in issuing the Form 1098s. For good measure, the complaint alleges that the bank “actively concealed” its reporting policy from its borrowers and that its actions caused “tens of thousands of taxpayers to unknowingly file erroneous tax returns which will have to be unwound at substantial cost” and that some of the homeowners will be precluded from getting relief from the IRS due to the passing of the statute of limitations on refund claims.
In response, in addition to disputing the class certification, on the merits the bank argues that the homeowners were free to report on the 1040s the correct amount of interest irrespective of the amount that the bank reported on the 1098. Moreover, the bank argues that Section 6050H of and the regulations under the statute did not require the bank to report the amount of interest attributable to the defaulted or deferred interest from the original loan. In addition, the bank argues that Section 7434 of the Internal Revenue Code, which does provide a federal cause of action for fraudulent information returns, does not include the Form 1098 for mortgage interest and that a violation of Section 6050H does not provide the basis for awarding damages to the homeowners.
I am sympathetic to the bank in its view that conduct that may run afoul of IRC Section 6050H does not trigger a private party’s cause of action and it is clear that Congress failed to include a 1098 as a type of return that can generate a private party’s suit against an issuer. On the other hand, BOA was wrong even if it is not actionable under 7434. The bank has a responsibility to get this right and it is unfair that the bank did not provide the requisite information for homeowners to readily compute the amount of interest that should be deductible. Homeowners, especially those going through traumatic financial times, should be able to rely on a Form 1098 they receive from a bank as a presumptively accurate statement of their deductible home mortgage interest.
In addition to the problems it creates for homeowners, BOA’s actions triggered problems for the IRS, which now must dedicate resources to address homeowners who may have questions or file amended returns to claim the proper amount of interest. BOA is the party with the information and resources to report the interest, and its actions have disadvantaged the homeowners and the IRS.
From a tax procedure and administration standpoint, the simple fix going forward is to clarify that banks are required to report under Section 6050H the total amount of interest paid, inclusive of past due interest amounts that are rolled over in a modified mortgage. That would provide an incentive for banks to get this right, as there are penalties the IRS can impose for failing to issue proper information returns. Moreover, perhaps Congress should amend Section 7434 to include Form 1098 as part of the covered information returns that can trigger a private party’s lawsuit against an issuer of the wrong information return. (I also question whether fraud alone should be required to tag an issuer with liability under 7434, and I address that briefly tomorrow, in my post on the case of Raley v BOA).
As a remedy in this case, apart from what Ms. Smith seeks, taxpayers could, subject to the statute of limitations on refund claims, go back and properly deduct the interest that they paid on the modified loans. Yet, it does seem possible that the court will find that remedy insufficient, and the class action aspect of the case is significant for many taxpayers (and plaintiffs’ lawyers). We will keep an eye on this case.