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Update on Issues Relating to Financial Institutions Underreporting Mortgage Interest to Millions of Consumers

Posted on Nov. 11, 2016

One of the most viewed posts on Procedurally Taxing in the last year or so was one that discussed a lawsuit alleging that Bank of America intentionally and systematically understated millions of dollars in homeowners’ mortgage interest payments following loan modifications. Earlier this year the lead attorney on that lawsuit, David Vendler of Morris Polich & Purdy, wrote a two-part post An Update on the Lawsuit Against Bank of America for Failing to Issue Accurate Interest Information Statements. When we last heard about the issue the IRS was seeking input through the Industry Issue Resolution program. Today David tells us that that the IRS has terminated that IIR project and added it to its list of guidance priorities for 2016-17. The issue is one with major implications for millions of consumers. The bankers are obviously well-represented in the guidance process. As David discusses there is a strong need for IRS and Treasury to hear how financial institutions should be required to report the payment of interest payments following loan modifications and other transactions like short sales when consumers are effectively paying substantial amounts of interest but not receiving information from banks that would allow them to determine whether the interest is deductible. Les

To all of you tax professionals reading this, I need your help.  Some of you may recall my two-part post regarding whether 26 U.S.C. section 6050H requires lenders and mortgage servicing entities to report payments of “capitalized” mortgage interest they receive from borrowers on IRS Form 1098 so that the borrowers can then deduct those payments.  The issue literally involves billions and billions of dollars in mortgage interest deductions that millions of American homeowners are losing because of the failure of their mortgage servicers to properly report.  As described in my prior posts, the situation arises in the contexts of negative amortization/Option Arm loans as well as loan modifications.  It also, however, arises with short sales, which was not discussed in my prior posts.  (Basically, if you look at the 1099-C that the consumer receives following a short sale, you will note that box 2 (which requires the reporter to indicate how much of the debt being cancelled is mortgage interest) is generally left blank.  This means that all of the cancelled debt is principal.  This is correct since mortgage notes generally require allocation of payments to interest before principal.  But in the short sale context, while the banks and mortgage servicers are correctly reporting the amounts of debt being cancelled, they are not reporting the other side of the transaction on Form 1098, which is the amount of interest being paid from the sales proceeds.  This amount can be in the tens of thousands of dollars)

Anyway, following my bringing lawsuits against certain banks arising from their failure to properly report their customers’ interest payments, the American Bankers Association and the Mortgage Bankers Association requested the IRS to address the issue.

In late December 2016 the IRS responded that it would address the issue via its Industry Issue Resolution (“IIR”) program.  This program, however, does not provide for public comment and I was afraid that the banks and the IRS would simply arrive at “guidance” that would conclude that section 6050H was ambiguous as to whether it required payments of capitalized interest to be reported.  This way, even if the IRS concluded that I was correct about the reportability of the interest, the banks could then use the “guidance” announcing that there was an ambiguity to “prove” that they did nothing wrong in not previously reporting  payments of capitalized interest.

In fact, however, there really is no ambiguity.  The law is very clear and can be stated in a single paragraph.  21 U.S.C. section 6050H unambiguously requires banks and mortgage servicers to report on Form 1098 the “aggregate” of all mortgage interest they receive in a year (if that amount is over $600).  The Supreme Court has held that “interest” unambiguously refers to money that has been charged for the use of money.  Deputy v. DuPont, 308 U.S. 488 (1940).  Case law further uniformly holds that payments of capitalized mortgage interest (whether in the loan modification context or the negative amortization loan context) are payments of mortgage interest that can be deducted in the year of payment.  See Copeland v. C.I.R., T.C. Memo. 2014-226, (capitalized pre-loan modification interest held deductible as mortgage interest in the year of payment); Smoker v. C.I.R., 2013 WL 645265 *6 (Tax Ct. 2013) (same holding in the negative amortization loan context) [note Les discussed Copeland on PT  here].  Since capitalization of interest does not change its character as interest (Motel Corporation v. Commissioner of Internal Revenue, 54 T.C. 1433, 1440 (1970)), payments of capitalized mortgage interest are part of the “aggregate” mortgage interest that banks and mortgage servicers “receive” and thus are required to be reported on Form 1098 by the plain and unambiguous language of section 6050H.  Indeed, it was for this very same reason why 26 CFR § 1.6050S-3(b)(1) specifically requires that payments of capitalized student loan interest be reported on Form 1098-S.  There is simply no logical distinction that can be made between the reportability of payments of capitalized student loan interest and capitalized mortgage interest.

After a bunch of submissions on my part to the IRS requesting to be included in the IIR process, the IRS has just last week declared that it is terminating the IIR process and will address the issue of the reportability of capitalized interest on Form 1098 by formal rulemaking.  I see this as very good news insofar as the public, including you, will have an opportunity to comment.  I further fully expect that whatever rule the IRS eventually publishes will be consistent with all of the law above since this was the conclusion the IRS reached on the reportability of student loan interest way back in 2004.  That said, I expect that there will be heavy pressure from the banks and mortgage servicing entities to push for a rule that is “prospective-only” as was done with the student loan interest rule back in 2004.  This will hurt consumers tremendously.  Banks should instead be required to issue corrected Forms 1098 to all consumers which will (retrospectively) inform them of the interest that was not reported to them and allow them to file an amended return (if the statute of limitations has not expired) to recover his/her deduction.  Further, if consumers are really to be helped, the IRS should include in its rule an exception to the statute of limitations (based on the fact that because of the bank’s misreporting, the consumer was unaware of the potential for amendment previously), or allow consumers to take the prior deductions in the current tax year.    There simply is no justification for a prospective-only rule precisely because the question of the reportability of payments of capitalized interest has already answered.  The mortgage industry just ignored that answer for the sake of reporting convenience.

So, what I would like from anyone who feels equipped to do so is to write to the IRS (prior to the official public comment period which comes after a proposed rule is formally announced) and let them know your thoughts.   Comments can be sent directly to prior to the formal public comment period.  Further, if any of you have any questions, please address them to me at

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