Lisa Milkovich v. United States
28 F.4th 1
| 9th Cir. | 2022Background
- Plaintiffs bought a Washington home in 2005, refinanced in 2006 (loan principal ~$744,993), and stopped mortgage payments in Feb. 2009.
- They filed Chapter 7 in Jan. 2010; the trustee abandoned the house and plaintiffs received a bankruptcy discharge in Apr. 2010, which eliminated personal (recourse) liability and converted the mortgage to nonrecourse.
- CitiMortgage later agreed to a short sale in July 2011; sale proceeds ≈ $555,006, CitiMortgage received ≈ $522,015 and allocated $114,688 to accrued interest and issued Form 1098 reporting interest received.
- Plaintiffs, cash-basis taxpayers, claimed a $114,688 mortgage interest deduction on their 2011 return; the IRS disallowed it, assessed tax, and after administrative denials plaintiffs sued for refund.
- The district court dismissed under Estate of Franklin (sham/debt-without-substance doctrine); the Ninth Circuit reversed, holding (on pleaded facts) the interest deduction was allowable and § 265 did not bar it.
Issues
| Issue | Plaintiff's Argument | Defendant's Argument | Held |
|---|---|---|---|
| Whether Estate of Franklin renders an originally valid mortgage a sham (no interest deduction) after property declines and short sale occurs | Franklin inapplicable — mortgage was valid ab initio; later market decline doesn't make the original debt a sham | Estate of Franklin principles should extend where mortgage greatly exceeds FMV at time of short sale | Reversed district court: Franklin limited to transactions lacking economic substance at inception; it does not apply to originally valid mortgages that later become underwater |
| Whether a short sale extinguishing nonrecourse debt produces COD income (§ 61(a)(11)) or is treated as sale proceeds (§ 61(a)(3)), and whether interest allocated at sale is paid/deductible | Short sale of nonrecourse debt is a single transaction under Tufts: discharged nonrecourse debt is included in amount realized; accrued interest allocated and received by lender is treated as paid by taxpayer and deductible under § 163 | IRS contends interest is not actually paid by taxpayers and any related amount may be tied to tax-exempt treatment, barring deduction under § 265 | Court: Tufts and related authorities govern; short sale of nonrecourse debt yields amount realized including discharged debt and accrued interest — plaintiffs deemed to have paid interest and are entitled to the deduction |
| Whether conversion of mortgage from recourse to nonrecourse by bankruptcy discharge generated taxable COD income that § 108 excluded and thus (via § 265) disallows the deduction | Conversion was not a "significant modification" under Treasury regs and did not create includible income; even if excluded under § 108, that exclusion is not a "wholly exempt" class of income for § 265 purposes | IRS argues discharge created tax-exempt COD income under § 108(a)(1)(A), so related interest expense is allocable to exempt income and barred by § 265(a)(1) | Court: No taxable COD income arose from the conversion (no significant modification); and § 108 exclusion does not render the income "wholly exempt" for § 265 because § 108 typically reduces tax attributes (deferment), so § 265 does not apply |
Key Cases Cited
- Commissioner v. Tufts, 461 U.S. 300 (nonrecourse obligation included in amount realized on disposition)
- Crane v. Commissioner, 331 U.S. 1 (principles on realization and treatment of encumbered-property dispositions)
- Estate of Franklin v. Commissioner, 544 F.2d 1045 (9th Cir.) (sham/economic-substance denial of interest where purchase lacked substance)
- Dewsnup v. Timm, 502 U.S. 410 (secured liens survive bankruptcy in rem even after discharge of personal liability)
- Beck v. Commissioner, 678 F.2d 818 (9th Cir.) (taxpayer must actually pay interest to deduct; discussion of bona fide debt character)
- Allan v. Commissioner, 856 F.2d 1169 (8th Cir.) (amount realized on foreclosure includes accrued interest and discharged nonrecourse debt)