United States District Court, W.D. Washington, Seattle
ORDER GRANTING MOTION TO DISMISS
Barbara Jacobs Rothstein, U.S. District Court Judge
Lisa Milkovich and Dan Nguyen (“Plaintiffs”)
initiated this action on November 15, 2018, alleging that
they are entitled to a tax refund in the amount of $18, 817
for the 2011 tax year. The United States of America
(“the United States”) moves to dismiss the action
pursuant to Federal Rule of Civil Procedure 12(b)(6) for
failure to state a claim on which relief may be granted. Dkt.
No. 10. Plaintiffs oppose the motion. Having reviewed the
motion, the opposition thereto, the record of this case, and
the relevant legal authorities, the Court will grant the
motion to dismiss. The reasoning for the Court's decision
purchased a personal residence (“the property”)
in February 2005 in Renton, Washington, for $744, 425. Dkt.
No. 1 ¶¶ 3.2-3.3. Plaintiffs' monthly payments
were approximately $3, 700. Id. at ¶ 3.6.
Plaintiffs were unable to maintain their monthly payments and
stopped making them in February 2009. Id. at
¶¶ 3.7-3.8. Thereafter, on January 25, 2010,
Plaintiffs jointly filed for relief under Chapter 7 of the
bankruptcy code. ¶ 3.14. The Chapter 7 trustee abandoned
the property due to lack of equity in March 2010, and
Plaintiffs received their Chapter 7 bankruptcy discharge in
April 2010. ¶¶ 3.15-3.16. Plaintiffs concede that
because they received a bankruptcy discharge, their mortgage
debt on the property was “nonrecourse, ” meaning
that they were not personally liable for it. ¶ 3.17,
Dkt. No. 12 at 1.
property was sold through a short sale in July 2011. Dkt. No.
1 at ¶ 3.8. At the time of the sale, unpaid interest
amounting to $114, 688 had accrued on the mortgage.
Id. ¶ 3.11. The mortgage holder, CitiMortgage,
received $522, 015 from the sale. The amount of the mortgage
at the time was $744, 992.95. CitiMortgage allocated the
money to satisfy the $114, 688 in accrued unpaid interest
first. ¶¶ 3.9-3.10. Thereafter, CitiMortgage issued
to Plaintiffs a Form 1098-MIS for 2011, which stated that it
received $114, 688 in mortgage interest. Dkt. No. 12 at 5.
deducted the $114, 688 mortgage interest from their 2011
taxes, which they claim should have resulted in a $18, 817
tax refund to them for that tax year. The IRS issued a notice
of deficiency proposing disallowance of the $144, 688
interest deduction plus penalties and interest. Dkt. No. 1 Â¶
3.18. The parties have been unable to resolve their dispute,
so Plaintiffs initiated this lawsuit seeking a refund of $18,
STANDARD OF REVIEW
under Federal Rule of Civil Procedure 12(b)(6) “is
proper only where there is no cognizable legal theory or an
absence of sufficient facts alleged to support a cognizable
legal theory.” Navarro v. Block, 250 F.3d 729,
732 (9th Cir. 2001). To survive a motion to dismiss, the
complaint must allege “enough facts to state a claim to
relief that is plausible on its face.” Bell Atl.
Corp. v. Twombly, 550 U.S. 544, 570 (2007). The Court
must “accept all factual allegations in the complaint
as true and construe the pleadings in the light most
favorable to the nonmoving party.” Rowe v. Educ.
Credit Mgmt. Corp., 559 F.3d 1028, 1029-30 (9th Cir.
2009) (citation and quotation omitted).
the parties do not have material differences when it comes to
the facts as alleged in the complaint. Instead, the
parties' dispute centers on statutory interpretation of
the meaning of the term “indebtedness” as it is
used in 26 U.S.C. § 163(a). Thus, it is appropriate for
the Court to resolve this dispute as a matter of law.
income tax deduction is a matter of legislative grace and . .
. the burden of clearly showing the right to the claimed
deduction is on the taxpayer.” INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 84 (1992) (internal quotation
marks omitted). Furthermore, “deductions are strictly
construed and allowed only as there is a clear provision
therefor.” Id. (same). This lawsuit involves
whether Plaintiffs are entitled to deduct from their 2011
income taxes mortgage interest that was paid on property
after they were discharged through bankruptcy from any
liability for the debt on said property and where the
outstanding mortgage amount exceed the fair market value of
the property. For the reasons set forth below, the answer is
Internal Revenue Code (“the Code”) provides that
“all interest paid or accrued within the taxable year
on indebtedness” will be allowed as a deduction.
Bergstrom v. United States, 37 Fed.Cl. 164, 169
(1996) (quoting I.R.C. § 163(a)). In fact, interest
deductions are generally allowed, even when the debt does not
subject the taxpayer to personal liability, i.e.
nonrecourse debt. Id. However, there is an exception
to this general rule when the nonrecourse liability (here,
the mortgage) exceeds a reasonable estimate of the fair
market value of the indebted property. In such a case, an
interest deduction is not allowed. Estate of Franklin v.
Commissioner, 544 F.2d 1045, 1048-49 (9th Cir. 1976). In
Franklin, the Ninth Circuit reasoned that if
nonrecourse liability exceeds a reasonable estimate of fair
market value, then the absence of personal liability may
“reduce the transaction in economic terms to a mere
chance that a genuine debt obligation may arise.”
Id. at 1049. In other words, the Ninth Circuit held,
the transaction lacks “economic substance” and
interest deductions cannot be allowed on such a transaction,
noting that interest deductions can exist only where the
“purchase money debt secured by the mortgage on the
acquired property does not deprive the debt of its character
as a bona fide debt obligation.” Id. (citing
Manuel D. Mayerson v. Commissioner, 47 T.C. 340, 352
(1966)). Ultimately, “[f]or debt to exist, the
purchaser, in the absence of personal liability, must
confront a situation in which it is presently reasonable from
an economic point of view for him to make a capital
investment in the amount of the unpaid purchase price.”
Id. (citing Mayerson, 47 T.C. at 352).
case falls squarely within the exception set forth by the
Franklin Court. Plaintiffs concede that their
mortgage debt on the property was discharged through
bankruptcy thus making it a “nonrecourse debt.”
Dkt. No. 12 at 1. Nor do the Plaintiffs challenge that the
fair market value of the property at the time of the short
sale was far below the outstanding mortgage debt and,
therefore, it was not “reasonable from an economic
point of view” for Plaintiffs to satisfy the mortgage
debt themselves. Thus, because the transaction lacked
“economic substance”, Plaintiffs are not
permitted to take a § 163 deduction on payments made to
satisfy the interest on that nonexistence debt. See also
Hildebrand v. Commissioner, 967 F.2d 350, 353 (9th Cir.
1992) (denying the deduction of interest for debt that was
nonrecourse and that lacked economic substance);
Odend'hal v. Commissioner, 748 F.2d 908, 912
(4th Cir. 1984) (stating that where the fair market value of
the property is less than that financed by a nonrecourse
loan, interest paid on the ...