March 3, 2022 - This Week at the Ninth

This Week at The Ninth: Short Sales and Ripeness

This week, the Ninth Circuit explores whether Twitter’s conflict with the Texas AG’s office over content moderation was ripe for review and when taxpayers may deduct mortgage interest payments after a short sale.

TWITTER, INC. V. KEN PAXTON

The Court holds that Twitter’s First Amendment challenge to the Texas attorney general’s demand to produce documents relating to content moderation decisions was prudentially unripe.

Panel: Judges Bennett, Nelson, and Bumatay, with Judge Nelson writing the opinion.

Key Highlight: “The issues here are not fit for judicial decision because the facts require further development, and the relative hardships to the parties support delaying review. The case thus is not prudentially ripe.”

Background: Twitter banned President Trump’s account after the events at the U.S. Capitol on January 6, 2021.  Texas AG accused the social media company of “closing conservative accounts,” and vowed that “[a]s AG, I will fight them with all I’ve got.”  A few days later, Paxton’s office served Twitter with a civil investigative demand seeking documents on its content moderation decisions.  Rather than respond to the demand or wait for an enforcement suit in Texas state court, Twitter sued Paxton in the Northern District of California, seeking to enjoin the investigation as unlawful retaliation for the company’s protected speech. The district court dismissed because, under the Supreme Court’s decision in Reisman v. Caplin, 375 U.S. 440 (1964), pre-enforcement challenges to non-self-executing document requests are not ripe.

Result: The Ninth Circuit affirmed.  First, the Court distinguished between constitutional and prudential ripeness.  Constitutional ripeness, the Court explained, is a jurisdictional prerequisite to suit, requiring that “the issues presented are definite and concrete, not hypothetical or abstract.”  Prudential ripeness, by contrast, is a non-jurisdictional threshold question, allowing the court to “evaluate both the fitness of the issues for judicial decision and the hardship to the parties of withholding court consideration.”  While courts generally address their jurisdiction first, “there is no mandatory sequencing of nonmerits issues,” and they may “dismiss a case on a non-merits threshold ground, if doing so is ‘the less burdensome course.’”

That was the case here, and the Court dismissed for lack of prudential ripeness without reaching any jurisdictional issues.  The issues presented were not fit for judicial review, the Court said, because addressing Twitter’s claim would require the district court to determine whether Twitter had made misrepresentations—the same issue that Paxton was trying to investigate.  “Allowing this case to go forward would force OAG to litigate the merits in a defensive posture in a different jurisdiction, without being able to investigate its own potential claims,” the Court reasoned, and “would limit many legitimate investigations” in other cases.  The balance of hardships also favored withholding consideration, the Court said.  “Twitter need not comply with the [demand], OAG has taken no action that requires immediate compliance,” and “any hardship to Twitter is minimized because Twitter may still raise its First Amendment claims before OAG brings an unfair trade practices suit.”  What’s more, the Court said, litigating the issue in federal court “would undermine Texas’s state sovereignty.”

The Court rejected reliance on several cases cited by Twitter, either because they did not directly address ripeness, or did not allow for some alternative way to raise a constitutional objection. But the Court also declined to rely on Reisman, as urged by Paxton, because it wasn’t a First Amendment case and also didn’t directly address ripeness.  Finally, because its “analysis is rooted in prudential ripeness and not equitable principles,” the Court said its decision applied equally to Twitter’s claims for equitable and declaratory relief.

MILKOVICH V. UNITED STATES OF AMERICA

The Court holds that, on the facts as pleaded, plaintiffs were entitled to claim a deduction for mortgage interest paid when, upon a short sale of plaintiffs’ home that extinguished a debt that had become nonrecourse after plaintiffs’ discharge from bankruptcy, the mortgagee applied a portion of the sale proceeds toward the plaintiffs’ accumulated unpaid interest on the secured loan.

The panel:  Judges Bybee, Collins, and Stearns (D. Mass.), with Judge Collins writing the opinion, and Judge Stearns dissenting.

Key highlight:  “Because . . . Plaintiffs are deemed at the short sale to have realized an amount that includes all of the discharged nonrecourse debt, including the accrued interest . . . they must for that further reason be deemed to have made the payment of interest that CitiMortgage received.  And because Plaintiffs paid that mortgage interest it was deductible under I.R.C. § 163(a), (h)(2)(D), (h)(3).”

Background:  Plaintiffs purchased a home for $748,425 and took out a mortgage.  Upon refinancing, the plaintiffs’ new mortgage had a principal amount of $744,993 and was ultimately held by CitiMortgage.  After plaintiffs became unable to continue making their monthly payments, they jointly filed for Chapter 7 bankruptcy, listing their home has having a current value of $600,000.  Because the value of plaintiffs’ home was well below the amount of CitiMortgage’s secured lien, the home had no value to creditors in the bankruptcy estate. And because the estate had no available distributable property, the trustee abandoned the assets of the estate with no distribution to creditors.  As a result, plaintiffs retained legal title to their home after the trustee’s abandonment.  Plaintiffs received a discharge from bankruptcy, which changed plaintiffs’ mortgage from recourse to nonrecourse.  Rather than foreclose on the property, CitiMortgage eventually agreed to a short sale, which is a real estate transition in which the property serving as collateral for a mortgage is sold for less than the outstanding balance on the secured loan, and the mortgage lender agrees to discount the loan balance because of a consumer’s economic distress.  The house sold for $555,005.92, of which about $522,015 was paid to CitiMortgage in satisfaction of the loan.  CitiMortgage credited $114,688 toward the accumulated unpaid interest on the secured loan and issued a Form 1098-Mortgage Interest Statement indicating it had received that amount in interest payments from plaintiffs.  Based on that state, plaintiffs claimed a $114,688 mortgage interest deduction that year. 

The IRS disallowed the $114,688 interest deduction on the ground that plaintiff did not establish the amount was an interest expense that was paid.  The IRS concluded that the interest deduction was properly disallowed under IRC § 265(a)(1), which precludes deductions that are allocable to one or more classes of income wholly exempt from the taxes imposed by this subtitle.  The IRS reasoned that plaintiffs had realized income from cancellation of debt of $222,977.95 at the short sale, but that plaintiffs were not required to recognize that income because it was non-recourse debt.  And because plaintiffs have unrecognized income from forgiveness of debt in excess of the accrued interest, they have no loss of income from that interest. 

After paying the tax, plaintiffs filed a civil action seeking a refund.  The district court dismissed the complaint for failure to state a claim.  The district court did not rely on the IRS’s prior reasoning, but instead reasoned that although interest deductions are generally allowed, plaintiffs’ interest payments fell under an exception established in Estate of Franklin v. Commissioner, 544 F.2d 1045, 1048-49 (9th Cir. 1976), for interest claimed in connection with purportedly debt-financed transactions that lacked economic substance.  Although plaintiffs were unlike the taxpayers in Estate of Franklin—who had acquired their debt liability in a transaction that lacked economic substance—the district court extended Estate of Franklin to cover validly issued mortgages that later resulted in short sales in which the nonrecourse liability (here, the mortgage) exceeds a reasonable estimate of the fair market value of the indebted property.  Because the fair market value of plaintiffs’ property had declined well below the mortgage balance, the district court concluded that the transaction lacked economic substance and any interest deduction related to that transaction was therefore barred.

Result:  The Ninth Circuit reversed, holding that, on the facts as pleaded, the plaintiffs were entitled to deduct the mortgage interest paid in connection with the short sale of their home.  The district court erred in extending the principles of Estate of Franklin to short sales involving mortgages that were valid ab initio.  That decision’s denial of an interest deduction was expressly limited to transactions substantially similar to the one there, where the purchase lacked the substance necessary to justify treating the transaction as a sale ab initio.  Here, in contrast, there was no suggestion that the plaintiffs acquired their original mortgage (or their refined mortgage) in a transaction that lacked economic substance so Estate of Franklin did not apply.

The Court also rejected the IRS’s alternative argument that IRC § 265(a)(1) precludes plaintiffs’ home mortgage interest deduction.  Where (as here) a short sale involves nonrecourse debt, the transaction does not give rise to cancellation-of-debt income that might trigger application of § 265.  And plaintiffs were entitled to deduct the interest payment because they were deemed to have paid it when CitiMortgage applied $114,688 to the payment of interest.  Plaintiffs’ bankruptcy discharge, which converted the mortgage from recourse to nonrecourse a year before the short sale, has no effect on the otherwise applicable tax treatment of the later short sale.

Stearns, J., dissented.  Judge Stearns concluded that the majority’s opinion was based on a fictional factual premise and a misreading of applicable law.  Factually, Judge Stearns explained that it was not the case that the plaintiffs “paid” the mortgage interest for which they sought a deduction, and no amount of “deeming” it so can make it otherwise.  And legally, Judge Stearns believed the majority had misinterpreted existing case law in concluding that a deduction was permissible in these circumstances.