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Taxpayer Sues Mortgage Servicer for Not Including Capitalized Interest on Form 1098

(Parker Tax Publishing July 2018)

A district court found several allegations made by a taxpayer regarding the alleged underreporting of mortgage interest by the entity to which she made her mortgage payments plausible and thus refused to dismiss them. The crux of the taxpayer's allegations were that (1) Code Sec. 6050H's use of the term "interest" includes deferred or capitalized interest, and (2) the amounts of interest stated in her 2011 and 2012 Forms 1098 were false because they did not account for deferred interest. Rovai v. Select Portfolio Servicing, Inc., 2018 PTC 195 (S.D. Calif. 2018).


Under Code Sec. 6050H, any person who is engaged in a trade or business and who receives at least $600 in home mortgage interest payments during a calendar year must report the amount of interest received to the IRS and to the individual who paid the interest.

In 2005, Adriana Rovai obtained an Option ARM home mortgage loan, the terms of which provided an option to make a monthly interest payment less than the full amount due. Under this option, the monthly interest Rovai did not pay was added to the principal amount of her loan and treated as principal for the purposes of the loan. In 2011, Select Portfolio Servicing, Inc. (SPS) became Rovai's loan servicer and received mortgage payments from her, which SPS applied to interest and principal due on the loan. When SPS took over servicing her mortgage loan in December 2011, Rovai's loan balance was $9,013 above her original loan balance, an amount which was charged as interest in the earlier years of her loan, which permitted her to defer mortgage interest for payment at a later date and added that deferred interest to principal. Thereafter, SPS respectively provided the IRS and Rovai with Forms 1098, which reported Rovai's payments on interest and principal for 2011. The amount of interest reported did not reflect deferred interest. When Rovai asked SPS to correct the Forms 1098 to reflect the deferred interest, it refused. Rovai filed a lawsuit in a California district court. The fundamental dispute between the parties was whether Code Sec. 6050H required SPS to report deferred interest payments.

Rovai's Allegations

Rovai alleged that (1) SPS failed to report millions of dollars in mortgage interest that it had actually received from consumers with Option ARM loans, (2) caused taxpayers to unknowingly file erroneous tax returns and permanently lose valuable tax deductions, and (3) caused Rovai to take a smaller tax deduction in 2013 and file an incorrect tax return. She further alleged that the IRS rejected attempts by taxpayers to seek a deduction for an interest amount higher than that reported in a Form 1098 and, because of that, she suffered substantial harm from SPS's conduct.

Specifically, Rovai filed claims for negligence, breach of contract, breach of the implied covenant of good faith and fair dealing, fraud, claims under California's Unfair Compensation Law (UCL), and requested for declaratory judgment.

In her suit, Rovai contended that SPS's reporting on Form 1098 violated Code Sec. 6050H. She alleged that the 2012 Form 1098 she received from SPS failed to report deferred interest payments and that SPS was negligent because it was under a legal duty pursuant to Code Sec. 6050H to report accurately the interest it received during each calendar year and a further duty to correct any mistakes on Forms 1098 as soon as possible after determining that a wrong amount had been reported. Rovai alleged that SPS breached its legal duties to her by failing to accurately report her interest payments on her 2011 and 2012 Forms 1098 and failing to correct the information reported after she complained. Rovai alleged that she had been damaged by SPS's negligence because of the IRS's policy of rejecting a return claiming an amount of interest that does not match the amount stated on a servicer-issued Form 1098.

The crux of Rovai's allegations were that (1) Code Sec. 6050H's use of the term "interest" includes deferred or capitalized interest, and (2) the amounts of interest stated in her 2011 and 2012 Forms 1098 were false because they did not account for deferred interest. Rovai cited the Supreme Court's decision in Old Colony Railroad Company v. Comm'r, 284 U.S. 552 (1931) to support her argument that interest is the price charged for the use of money and thus includes capitalized interest.

Challenges in Code Sec. 6050H Reporting

The district court noted that federal courts have proceeded with caution in addressing challenges to Code Sec. 6050H reporting by mortgage lenders and servicers, like the challenge Rovai raised, even when those challenges present familiar state law claims. This is because, the court said, neither Code Sec. 6050H nor its implementing regulations provide explicit directions on how, whether, and when to report capitalized interest. According to the district court, state law claims incorporating Code Sec. 6050H-based challenges raise novel issues that have given federal courts pause, particularly because of the IRS's role in the federal tax scheme. The court noted that, despite the filing of five class actions in federal courts concerning Code Sec. 6050H reporting, with the earliest filed some six years ago, the IRS has not weighed in on Code Sec. 6050H's scope.

District Court's Analysis

With respect to Rovai's reliance on the Old Colony Railroad Company decision, the court found Rovai's reliance flawed. While Rovai would characterize the question as a simple undertaking of statutory construction, the court said, that is "quite frankly not the case." According to the court, it cannot be said, based on a plain reading of Code Sec. 6050H, whether or not the statute's use of the term "interest" encompasses capitalized interest. The court noted that multiple courts have expressly acknowledged, "[n]either Sec. 6050H nor its implementing regulations provide explicit direction to recipients on how, whether and when to report capitalized interest." And, the court noted, the IRS has not made any pronouncement regarding what Code Sec. 6050H requires with respect to reporting of deferred interest. Nor, the court observed, has any federal court adopted the statutory construction Rovai advanced. The court said that if it were to do adopt the statutory construction advanced by Rovai, prior case law counseled that it could not be used to show that SPS's reporting in 2011 and 2012 was false when made because the law did not unambiguously set forth clear requirements for reporting deferred interest payments

According to the court, although the IRS may very well adopt Rovai's position on Code Sec. 6050H reporting at a later point and even if it were to consider Rovai's position to be reasonable, this could not show SPS's knowledge of falsity at the time it issued the 2011 and 2012 Forms 1098. Rovai's allegations regarding SPS's intent to defraud fared no better. Mere conclusory allegations that representations or omissions were intentional and for the purpose of defrauding and deceiving, the court said, are insufficient to establish fraud.

While rejecting most of Rovai's claims, the court concluded that some had merit. The court dismissed (1) the claims for breach of contract, breach of the implied covenant of good faith and fair dealing, and claims of fraud, (2) one prong of the claim relating to California's UCL, and (3) the declaratory judgment claim. The court also dismissed Rovai's claim for a preliminary and permanent injunction. However, the court allowed a second prong of the UCL claim, as well as the negligence claim, to go forward.

For a discussion of the Code Sec. 6050H reporting requirement, see Parker Tax ¶252,505.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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