IRS RULES ON MORTGAGE INTEREST REFUNDS.

Rev. Rul. 92-91

ISSUES

(1) Is an interest overcharge, which a homeowner paid as the result of a financial institution's miscalculation of interest on an adjustable rate mortgage (ARM), deductible by the homeowner in the year of payment as qualified residence interest under section 163(h)(3) of the Internal Revenue Code?

(2) Is the homeowner's recovery of the interest overcharge in a subsequent year includible in the homeowner's gross income in the year of recovery if the homeowner's deduction of the interest overcharge reduced the homeowner's federal income tax in a prior tax year?

FACTS

In 1990, BK, a financial institution that services and owns home mortgages, notified A, an individual homeowner, that A was required to pay interest in the amount of $10,000 on an ARM for 1990. A, who is a calendar year taxpayer, uses the cash receipts and disbursements method of accounting, and files a joint federal income tax return, paid BK $10,000 as interest due on the ARM in 1990. BK included the $10,000 as interest on the Form 1098, Mortgage Interest Statement, that it filed with the Internal Revenue Service for the 1990 calendar year and on the copy of the Form 1098 that it sent to A for that year.

The ARM obtained by A from BK at all times qualified as either acquisition indebtedness or home equity indebtedness with respect to a qualified residence of A, so that the interest A paid to BK on the ARM would be qualified residence interest under section 163(h)(3) of the Code. Thus, A deducted the $10,000 A paid to BK as qualified residence interest on A's 1990 federal income tax return that A timely filed in April of 1991. A's total itemized deductions for 1990 were $15,000 (including the $10,000 A paid to BK). The standard deduction that A could have claimed in 1990 was $5,450.

In June of 1991, discovered a $700 overcharge of the interest due on A's ARM in 1990. BK immediately paid A $750, an amount that represented a refund of the $700 interest overcharge and $50 in interest on that overcharge. A included the $700 interest overcharge and the $50 in interest in gross income for 1991.

LAW AND ANALYSIS

ISSUE 1: INTEREST DEDUCTION

Section 163(a) of the Code generally allows a deduction for all interest paid or accrued within the taxable year on indebtedness.

Although section 163(h)(1) of the Code provides that no deduction for personal interest is allowed to noncorporate taxpayers, section 163(h)(2)(D) provides that personal interest does not include qualified residence interest.

Under section 163(h)(3)(A) of the Code, "qualified residence interest" generally is defined as any interest that is paid or accrued on acquisition indebtedness or home equity indebtedness with respect to any qualified residence of the taxpayer. Under section 163(h)(3)(B), "acquisition indebtedness" is any indebtedness that is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer and is secured by such residence. Under section 163(h)(3)(C), "home equity indebtedness" is any indebtedness (other than acquisition indebtedness) secured by a qualified residence. In general, acquisition indebtedness may not exceed $1,000,000, and home equity indebtedness may not exceed $100,000.

Section 461 of the Code provides that the amount of any deduction or credit allowed by subtitle A of the Code shall be taken for the taxable year that is the proper taxable year under the method of accounting used in computing taxable income.

Section 1.461-1 of the Income Tax Regulations provides that under the cash receipts and disbursements method of accounting, amounts representing allowable deductions generally must be taken into account for the taxable year in which they are paid.

As a general rule, a taxpayer is not allowed a deduction for a payment for which no liability exists or reasonably appears to exist. See Kenyon Instrument Co. v. Commissioner, 16 T.C. 732 (1951), in which the court denied a deduction for state franchise taxes to the extent the taxpayer knew it was not liable for the taxes.

However, when a taxpayer is notified that payment of a liability is due, and the taxpayer in good faith pays the liability, the taxpayer may properly deduct the payment (if a deduction is otherwise allowable) in the taxable year it is made, even though the payment is determined to be erroneous in a subsequent taxable year. See Baltimore Transfer Co. v. Commissioner, 8 T.C. 1 (1947), acq., 1947-2 C.B. 1, in which the court allowed a taxpayer to deduct overpayments made to a state unemployment compensation fund in one year that were based on an erroneous notification to the taxpayer by the fund that was not corrected until the following tax year. The court concluded that the taxpayer acted reasonably in accepting as correct the fund's administrative determination of the amount owed by the taxpayer.

In this case, BK notified A of the interest due on the ARM for 1990 and A, in good faith, paid this amount in 1990. BK did not inform A until June of 1991 that BK had erroneously determined (and billed A for) the amount of interest due on the ARM. Therefore, on A's 1990 federal income tax return, A properly deducted the $700 overpayment A made to BK in 1990 as qualified residence interest under section 163 of the Code.

ISSUE 2: INCOME INCLUSION

Section 61(a) of the Code provides that, except as otherwise provided by law, gross income means all income from whatever source derived. Section 61(a)(4) provides that interest is an item of gross income.

Section 111 of the Code excludes from gross income amounts attributable to the recovery during the taxable year of any amount deducted in any prior year to the extent that the amount did not reduce the amount of tax imposed by chapter 1 of subtitle A of the Code.

Section 111 of the Code is a partial codification of the tax benefit rule, which generally requires the inclusion in income of amounts that were deducted by a taxpayer in a prior tax year to the extent those amounts generated a tax benefit to the taxpayer through a reduction in the amount of tax liability in the prior tax year. See generally, Estate of Block v. Commissioner, 39 B.T.A. 338 (1939), aff'd sub nom. Union Trust Co. v. Commissioner, 111 F.2d 60 (7th Cir. 1940), cert. denied, 311 U.S. 658 (1940). The tax benefit rule is applied when a subsequent event occurs which is fundamentally inconsistent with the premise on which an earlier deduction was based. The purpose of the rule is to achieve rough transactional parity within the framework of a tax system requiring annual calculations. See Hillsboro National Bank v. Commissioner, 460 U.S. 370 (1983), 1983-1 C.B. 50.

The amount of an interest overcharge reimbursement that is includible in gross income under the tax benefit rule is the lesser of (1) the reimbursement, or (2) the amount by which the taxpayer's itemized deductions in the year of the interest overcharge exceeded the standard deduction.

In this case, A received a $700 reimbursement in 1991 attributable to A's 1990 mortgage interest deduction. The $700 reimbursement is less than $9,550, the amount by which A's total itemized deductions in 1990 ($15,000) exceeded the standard deduction ($5,450) that A could have claimed for that year. Therefore, the tax benefit rule requires that A include the $700 reimbursement in A's gross income in 1991. In addition, the $50 in interest on the $700 reimbursement that A received must be included in A's gross interest in 1991 under section 61(a)(4) of the Code.

HOLDINGS

(1) An interest overcharge, which a homeowner paid as the result of a financial institution's miscalculation of interest on an adjustable rate mortgage (ARM), is deductible by the homeowner in the year of payment as qualified residence interest under section 163(h)(3) of the Code.

(2) The homeowner's recovery of the interest overcharge in a subsequent year is includible in the homeowner's gross income in the year of recovery to the extent that the homeowner's deduction of the interest overcharge reduced the homeowner's federal income tax in a prior tax year. This result requiring income inclusion in the year of recovery is the same whether the financial institution refunds the interest overcharge to the homeowner or reduces the outstanding principal on the homeowner's mortgage by the amount of the interest overcharge.

DRAFTING INFORMATION

The principal author of this revenue ruling is George Kelley of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Mr. Kelley on (202) 622-4910 (not a toll-free call).