Payment from Qualified Settlement Fund For Foreclosure Irregularities Is Fully Taxable to Recipient

Clients who receive legal settlements often believe that because they have been awarded damages for a wrong that occurred the payment is not subject to income taxes.  But the tax law is not so simple.  The default under federal tax law, found at IRC §61(a), is that all items of income are taxable, with the burden falling on the taxpayer to point out an exception that applies in his/her case.

The case of Ritter v. Commissioner, TC Memo 2017-185, looks at an award received by a homeowner whose house was taken in a foreclosure proceeding.  The taxpayer received a payment related to a settlement between the lender and the government to deal with, as the Office of the Comptroller of the Currency labeled it, “deficiencies and unsafe or unsound practices in [Chase Bank’s] residential mortgage servicing and in the Bank’s initiation and handling of foreclosure proceedings.”

The settlement agreement provided that the bank would establish a “qualified settlement fund” (QSF) within the meaning of Treas. Reg. §1.468B-1.  Payments from this fund would be made to various qualified homeowners.  The homeowners would not be required to show any specific financial harm to receive a payment from the fund.  As well, the settlement agreement provided that the payments were not for any specific financial injury or harm to the borrowers, and no portion of the award was designated for lost equity.

Mr. Ritter received a check for $31,250 from the QSF.  The QSF issued a 2013 Form 1099-MISC to Mr. Ritter showing the payment as “other income” for 2013.  Along with the 1099 was a letter that explained this amount related to the payment Mr. Ritter received related to his mortgage.

Whether a payment as part of a legal settlement is taxable to the recipient requires a determination of why the damages were being awarded—was it to reimburse a taxpayer for a specific financial cost that had been incurred, did it represent addition amounts the taxpayer should have received for the disposition of the home, etc.  Unless the taxpayer establishes a “why” that has a specific exception from taxation, the proceeds would be taxable.

This case involved the special tax entity known as a qualified settlement fund as described in IRC §468B. As the Court notes:

Section 468B and the regulations thereunder provide special rules for the taxation of a designated settlement fund, like the QSF. Pursuant to section 1.468B-4, Income Tax Regs., whether a distribution from a designated settlement fund, like the QSF, is includible in a payee’s gross income is generally determined by reference to the claim in respect of which the distribution is made and as if the distribution were made directly to the payee by the transferor to the designated settlement fund.

In this case, the Court found that the payment did not meet any criteria that would allow it to be excluded from income:

The distribution plan for distributions from the QSF established different categories of borrowers that were based upon different loan file characteristics and whether the borrower requested a review through the IFR. The OCC and the Federal Reserve Board determined in their sole discretion a specific payment amount, a so-called standard payout amount, for each category of borrowers. Pursuant to the distribution plan, petitioner was categorized as a borrower who did not request review through the IFR and whose mortgage loan servicer (i.e., Chase Bank) initiated or completed foreclosure with respect to the mortgage loan on petitioner’s then principal residence while he was protected by Federal bankruptcy law. Petitioner’s category of borrowers was not eligible for a payment representing lost equity. Like all borrowers so categorized, the OCC and the Federal Reserve Board had determined that the standard payout amount payable to petitioner’s category of borrowers was $31,250.

The fully stipulated record is devoid of evidence establishing that the $31,250 payment was, or was intended to be, a deemed increase or decrease in the amount realized by petitioner from the foreclosure with respect to the mortgage loan on his then principal residence. Nor does that record contain any evidence establishing that petitioner is entitled under a specific Code section to exclude that payment from gross income.