This Week at The Ninth: Short Selling and Maturity | Morrison & Foerster LLP – Left Coast Appeals
This week, the Ninth Circuit explores whether Twitter’s dispute with the Texas AG office over content moderation was ripe for review and when taxpayers can deduct mortgage interest payments after a short sale.
The Court finds that Twitter’s First Amendment challenge to the Texas Attorney General’s request to produce documents relating to content moderation decisions was not prudentially mature.
Sign: Judges Bennett, Nelson and Bumatay, with Judge Nelson writing the opinion.
Climax“The issues here are not worthy of judicial determination because the facts require further development, and the relative difficulties of the parties justify delaying consideration. The case is therefore not prudentially mature.
context: Twitter banned President Trump’s account after the events at the United States Capitol on January 6, 2021. Texas AG accused the social media company of “shutdown conservative accounts” and swore that “[a]s AG, I will fight them with everything I have. A few days later, Paxton’s office served Twitter with a Civil Inquiry Request requesting documentation of its content moderation decisions. Rather than respond to the request or wait for legal action in Texas state court, Twitter sued Paxton in the Northern District of California, seeking to have the investigation barred as unlawful retaliation for the company protected speech. The District Court dismissed because, in accordance with the Supreme Court’s decision in Reisman v. Caplin375 US 440 (1964), pre-execution challenges to non-self-executing document requests are not ripe.
Results: The Ninth Circuit confirmed. First, the Court distinguished between constitutional maturity and prudential maturity. Constitutional maturity, the Court explained, is a jurisdictional precondition for prosecution, requiring that “issues presented be definite and concrete, not hypothetical or abstract.” Prudential maturity, on the other hand, is a non-jurisdictional threshold question, allowing the court “to assess both the suitability of the questions for judicial determination and the difficulty for the parties to refuse consideration by the court”. While courts generally deal with their jurisdiction first, “there is no mandatory sequencing of unfounded issues” and they can “dismiss a case on an unfounded threshold ground, if that is” the less burdensome route. “.
This was the case here, and the Court dismissed it for lack of prudential maturity without addressing any jurisdictional issue. The issues presented were not amenable to judicial review, the court said, because dealing with Twitter’s complaint would require the district court to determine whether Twitter had made false statements — the same issue on which Paxton tried to investigate. “Allowing this case to proceed would require OAG to argue the merits in a defensive position in a different jurisdiction, unable to investigate its own potential claims,” the court explained, and “would limit many legitimate investigations.” in other cases. The balance of hardship also favored restraint, the court said. “Twitter does not have to comply with the [demand]OAG has not taken any action requiring immediate compliance”, and “any difficulty for Twitter is minimized because Twitter can still raise its First Amendment claims before OAG takes legal action for unfair trade practices”. Moreover, the court said, litigating the issue in federal court “would undermine the sovereignty of the state of Texas.”
The Court rejected the use of several cases cited by Twitter, either because they did not deal directly with maturity or because they did not allow another way to raise a constitutional objection. But the Court also refused to rely on Reisman, as requested by Paxton, because it was not a First Amendment case, nor did it directly address maturity. Finally, because its “analysis is rooted in prudential maturity and not equitable principles,” the Court said its decision also applied to Twitter’s claims for equitable and declaratory relief.
The Court finds that, on the facts as pleaded, the plaintiffs were entitled to claim a deduction for the mortgage interest paid when, in a short sale of the plaintiffs’ house which extinguished a debt Having become without recourse after the plaintiffs were released from bankruptcy, the mortgagee sought a portion of the sale proceeds towards the unpaid interest accrued by the plaintiffs on the secured loan.
The panel: Per Bybee, Collins and Stearns JJ. (D. Mass.), Judge Collins writing the opinion and Judge Stearns dissenting.
Climax : “Because . . . Upon the short sale, plaintiffs are deemed to have realized an amount which includes the entire non-recourse debt discharged, including accrued interest . . . they must for this additional reason be deemed to have made the interest payment that CitiMortgage received. And because the plaintiffs paid that mortgage interest, it was deductible under IRC § 163(a), (h)(2)(D), (h)(3) ).
Context: The plaintiffs bought a house for $748,425 and took out a mortgage. Upon refinancing, the plaintiffs’ new mortgage had a principal of $744,993 and was ultimately owned by CitiMortgage. After the plaintiffs became unable to continue making their monthly payments, they jointly filed for Chapter 7 bankruptcy, listing that their home had a current value of $600,000. Because the value of the plaintiffs’ home was well below the secured lien amount of CitiMortgage, the home had no value to creditors of the bankruptcy estate. And because the estate had no distributable assets available, the trustee abandoned the estate’s assets without distribution to creditors. Accordingly, the plaintiffs retained legal title to their home after the trustee’s abandonment. The plaintiffs received a bankruptcy discharge, which changed the plaintiffs’ mortgage from recourse to non-recourse. Rather than foreclose on the property, CitiMortgage ultimately 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 of the secured loan, and the mortgage lender agrees to discount the loan balance due to a consumer’s economic distress. The house sold for $555,005.92, of which approximately $522,015 was paid to CitiMortgage in settlement of the loan. CitiMortgage credited $114,688 of the unpaid interest accrued on the secured loan and issued a Form 1098-Mortgage Interest Statement indicating that it had received this amount in interest payments from the plaintiffs. Based on this statement, plaintiffs claimed a mortgage interest deduction of $114,688 that year.
The IRS denied the interest deduction of $114,688 on the grounds that the plaintiff had failed to establish that the amount was a paid interest expense. The IRS has concluded that the interest deduction is properly disallowed under IRC § 265(a)(1), which excludes deductions attributable to one or more classes of income fully exempt from taxes imposed by this subtitle. . The IRS estimated that the plaintiffs realized debt forgiveness income of $222,977.95 from the short sale, but the plaintiffs were not required to recognize this income because it was of a non-recourse debt. And because plaintiffs have unrecognized income from debt cancellation that exceeds accrued interest, they have no loss of income from that interest.
After paying the tax, the plaintiffs brought a civil action seeking a refund. The district court dismissed the complaint for failure to report. The district court did not rely on the IRS’ earlier reasoning, but instead held that although interest deductions are generally permitted, plaintiffs’ interest payments fell within an exception set forth in Estate of Franklin c. Commissioner, 544 F.2d 1045, 1048-1049 (9th Cir. 1976), for interest claimed in allegedly debt-financed transactions that lacked economic substance. Even if the plaintiffs were different from the taxpayers in Franklin Estate– who had acquired their debt in a transaction that lacked economic substance – the District Court extended Estate of Franklin to cover validly issued mortgages which then resulted in short sales in which liability without recourse (here, the mortgage) exceeds a reasonable estimate of the fair market value of the indebted property. Because the fair market value of the plaintiffs’ property had fallen well below the mortgage balance, the district court found that the transaction lacked economic substance and any interest deductions related to this transaction were therefore prohibited.
Results: The Ninth Circuit reversed, finding that, on the facts alleged, 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 Franklin Estate short sales relating to mortgages valid ab initio. The denial of an interest deduction by this decision was expressly limited to transactions substantially similar to this one, where the purchase did not have the necessary substance to justify treating the transaction as an ab initio sale. Here, on the other hand, there was no indication that the plaintiffs had acquired their original mortgage (or their refined mortgage) in a transaction that lacked economic substance, so Franklin Estate did not apply.
The Court also rejected the IRS’ alternative argument that IRC § 265(a)(1) excludes the deduction of plaintiffs’ mortgage interest. Where (as here) a short sale involves non-recourse debt, the transaction does not give rise to debt forgiveness income that could trigger Section 265. And plaintiffs were entitled to deduct the interest payment because they were deemed to have paid it when CitiMortgage applied $114,688 towards the interest payment. The plaintiffs’ bankruptcy discharge, which converted the mortgage from recourse to non-recourse one year before the short sale, has no effect on the otherwise applicable tax treatment of the subsequent short sale.
Stearns, J., dissenting. Justice Stearns found that the majority opinion was based on a fictitious factual premise and a misreading of the applicable law. In fact, Judge Stearns explained that it was not true that the plaintiffs had “paid” the mortgage interest for which they claimed a deduction, and no amount of “presumption” can make otherwise. And legally, Justice Stearns held that the majority had misinterpreted the existing case law in concluding that a deduction was permitted in these circumstances.