When advising clients on complex debt relief transactions, it is crucial to understand not only the substantive law governing the timing of income recognition but also the procedural prerequisites for challenging IRS determinations. The recent Summary Order issued by the United States Court of Appeals for the Second Circuit in Romeo Salta, Jr., Phyllis Polega v. United States of America, 24-2700-cv (Oct. 6, 2025), affirmed the District Court’s finding regarding the proper tax year for cancellation-of-indebtedness (COI) income and provided a stark reminder of the binding nature of the doctrine of variance.

Factual Background and Taxpayer Reporting

The case originated from the reporting of cancellation-of-indebtedness income by Romeo Salta, Jr. and Phyllis Polega on their 2015 joint tax return. This COI income stemmed from the discharge of Salta’s mortgage debt related to the Point Lookout Property in New York.

In January 2015, the Point Lookout Property was under foreclosure. Salta executed a deed-in-lieu-of-foreclosure arrangement, whereby he relinquished his rights to possess the property and transferred the deed to the mortgagee. In exchange for this transfer, the mortgagee and the mortgage loan servicer waived their rights to pursue a deficiency judgment against Salta. The consideration received by Salta for the deed transfer included the "full cancellation of all debts . . . [and] obligations . . . secured by" the mortgage on the Point Lookout Property. This arrangement was formalized in the January 2015 Relocation Agreement signed by Salta and the loan servicer, as well as several other contemporaneous documents.

The Taxpayers’ Request for Relief

Salta and Polega subsequently requested a refund from the Internal Revenue Service (“IRS”) and brought a refund suit against the government. They sought the return of $113,087 in taxes paid on the debt cancellation. Their position was that the cancellation-of-indebtedness income was properly taxable in the 2017 tax year, rather than the 2015 tax year in which they initially reported it. The district court granted summary judgment in favor of the government, leading to the appeal.

The Governing Tax Law on Discharge of Indebtedness

The Court of Appeals reviews a decision granting summary judgment de novo; summary judgment is appropriate if there is no genuine issue as to any material fact, and if the moving party is entitled to judgment as a matter of law; Gudmundsson v. United States, 634 F.3d 212, 216–217 (2d Cir. 2011).

The substantive issue required the court to analyze the timing of debt cancellation under the Internal Revenue Code. Generally, “Income from discharge of indebtedness” is considered taxable income pursuant to 26 U.S.C. § 61(a)(11); see Gitlitz v. Comm’r, 531 U.S. 206, 213 (2001).

For tax purposes, debt is deemed discharged at the "moment it becomes clear that [the] debt will never have to be paid"; Cozzi v. Comm’r, 88 T.C. 435, 445 (1987). This determination hinges on "[a]ny identifiable event which fixes the loss with certainty"; Cozzi, 88 T.C. at 445 (quotation marks omitted); see Hohl v. Comm’r, 121 T.C.M. (CCH) 1016, at *13 (2021).

Application of the Law to the Facts

The district court’s finding that the COI income accrued in the 2015 tax year was affirmed. The Second Circuit agreed that the deed-in-lieu-of-foreclosure transaction finalized in January 2015 was the requisite "identifiable event". Through this arrangement, the mortgagee "in essence accept[ed] the property itself as full satisfaction for the amount owed on the mortgage loan, leaving the mortgagor with no remaining debt".

Because the January 2015 transaction fixed the cancellation of debt with certainty, making it "clear that [Salta’s mortgage] debt will never have to be paid," the debt must be viewed as having been discharged in 2015; Cozzi, 88 T.C. at 445 (quotation marks omitted). Therefore, 2015 was the proper tax year for recognizing the cancellation-of-indebtedness income.

The Critical Procedural Barrier: The Doctrine of Variance

On appeal, Salta and Polega introduced a new contention: that the January 2015 Relocation Agreement was not enforceable during 2015. The Court of Appeals found that this argument was barred by the doctrine of variance because the taxpayers had not presented this specific contention to the IRS during their administrative claim.

The Rule: A taxpayer must first file an administrative claim for a refund with the IRS before initiating a refund suit; Apollo Fuel Oil v. United States, 195 F.3d 74, 77 (2d Cir. 1999) (per curiam) (citing 26 U.S.C. § 7422(a) (1994)). The doctrine of variance dictates that the taxpayer must advance in the administrative proceeding "any contention it wishes to pursue in court"; Apollo Fuel Oil, 195 F.3d at 77. Consequently, in a refund suit, a taxpayer "may not raise different grounds than those brought to the IRS"; Magnone v. United States, 902 F.2d 192, 193 (2d Cir. 1990) (per curiam).

The Purpose: The primary purpose of the variance rule is "to prevent surprise, and to give the IRS adequate notice of the claim and its underlying facts so that it can make an administrative investigation and determination regarding the claim"; McDonnell v. United States, 180 F.3d 721, 722 (6th Cir. 1999).

Application of the Variance Doctrine: Salta and Polega conceded that their refund claim submissions (the 2015 amended joint return and Salta’s 2017 return) failed to challenge the validity of the Relocation Agreement. Instead, they relied exclusively on conflicting tax filings made by the loan servicer and a statute of limitations theory that was subsequently abandoned. Because these administrative filings did not give the IRS "adequate notice" of the contract unenforceability argument and its underlying facts, the IRS could not conduct an investigation or determination on that specific claim; McDonnell, 180 F.3d at 722. Therefore, the unenforceability argument was not properly pursued in court; Apollo, 195 F.3d at 77.

Taxpayer’s Attempted Exception

Salta and Polega attempted to circumvent the variance doctrine by asserting that they could not have raised the unenforceability theory in their administrative filings because they only discovered years later that the mortgagee "never signed the documentation creating a binding and enforceable contract in 2015".

The Second Circuit rejected this attempt on two grounds:

Lack of Legal Authority: The taxpayers failed to cite—and the court was unaware of—any legal authority creating an exception to the variance doctrine simply because a taxpayer learns after filing a refund request that a private contract may have been unenforceable.
Knew or Reasonably Should Have Known: Crucially, the court determined that Salta and Polega knew or reasonably should have known the facts underpinning their unenforceability theory back in January 2015. The documents signed by Salta, including the Relocation Agreement and the Agreement in Lieu of Foreclosure, clearly indicated on their face that the mortgagee had not signed them, and the Relocation Agreement lacked a place for the mortgagee to sign.

Furthermore, regarding Salta’s assertion that he did not discover the loan servicer’s "lack of a power of attorney" until discovery in the refund action: a party that deals with an agent "does so at [his] peril, and must make the necessary effort to discover the actual scope of authority"; Sherrod v. Mount Sinai St. Luke’s, 204 A.D.3d 1053, 1058 (2d Dep’t 2022) (quotation marks omitted). The failure to verify the loan servicer’s authority before signing the Relocation Agreement was not considered a sufficient basis to bypass the variance doctrine.

Conclusion

The Second Circuit found Salta and Polega’s remaining arguments to be without merit and AFFIRMED the order of the district court. This summary order reinforces that the timing of COI income recognition is fixed by the "identifiable event" of the debt cancellation—in this case, the execution of the deed-in-lieu transaction in 2015. More importantly for tax practitioners, the ruling serves as a vital caution: all grounds for relief must be fully articulated and supported by underlying facts in the initial administrative claim (such as a Form 1040X) filed with the IRS, as failure to do so will result in procedural variance barring judicial review of the new issue.

Prepared with assistance from NotebookLM.