"Prepaid" mortgage interest refund

[Don Hermanson]

A client recently received a letter from their mortgage holder, Chase Bank. They closed on their home mortgage in 2011. The recent letter (received Feb 2012) stated that the bank had discovered that they (bank) had failed to give them the required 3 days notification of time Truth in Lending Act) before the closing concerning the fact that their APR had increased during the application process, and therefore they were sending them a check for the difference between the old rate and the new rate...for the life of the loan! The check was for $63,000+!

The obvious question: what is the tax consequence? I have reasoned that they will be getting a Form 1098 each year for the life of the loan that states the amount of interest paid with the new higher rate. They would then (from an amortization schedule for the previous rate acquired from the bank, I suppose) subtract the difference of interest that would have been paid with the old and new rate, and subtract this amount from the Form 1098 amount to be put on Schedule A. Of course if it is all taxable income for 2012, Chase will send them a 1099, but that won't arrive until Jan 2013, and they would like to know what to do with the money now!

Any thoughts?

[Koss]

Mortgage Interest Rate

That's bizarre.

Don Hermanson wrote:

Of course if it is all taxable income for 2012, Chase will send them a 1099.

I'm not convinced that it is taxable income, and I'm not convinced that Chase will send them a 1099.

A refund of mortgage interest would be taxable only if it was previously deducted on Schedule A.

Characterizing the check as a refund is not entirely accurate. The bank can't refund something that the borrower has not yet paid.

they would then (from an amortization schedule for the previous rate acquired from the bank, I suppose) subtract the difference of interest that would have been paid with the old and new rate, and subtract this amount from the Form 1098 amount to be put on Schedule A.

This makes sense. But if they are deducting the correct amount of interest, and not that portion of the interest that they didn't really pay because of the refund check, then that only strengthens my argument that the amount of the check is not taxable income.

The bank might back out the applicable amount for them when they issue the 1098. Either way, the refund should not be taxable.

If it is treated as taxable income, then they should be able to deduct all of the mortgage interest each year, at the higher (incorrect) rate.

The whole thing doesn't make sense. I don't understand why the bank can't immediately modify the interest rate on the mortgage, thereby lowering the monthly payment. That would have eliminated the need to issue a "refund."

I firmly believe that the check they received is not taxable. But if it is, the bank's conduct is outrageous, and they should have been given a choice to take the check or lower the payment. That check could easily push them into a higher tax bracket. And that's only the tip of the iceberg. What if that "income" has an impact on a college financial aid application?

It's not taxable income.

The bank should have refunded the excess interest that the borrower already paid, and modified the interest rate going forward.

This might actually be a clerical error at the bank. It's unlikely, but I wouldn't rule it out. I don't understand how a check that large could have gone out without some sort of review or dual control. But if it is a mistake, they may well be required to return the money.

Maybe this sort of massive "prepaid refund" is actually required, by some provisions of the Truth in Lending Act, when the bank screws up like this. But even that seems far-fetched.

Umm...

What happens if they pay off the loan early, by selling the house or refinancing?

...and they would like to know what to do with the money now!

I can think of a lot of things that I would do with that kind of money. The real question is, do they want the lump sum, or would they prefer to have the lower monthly payment?

They could ask the bank to take the money back, and recalculate their mortgage loan using the correct interest rate.

By accepting the money, they are effectively agreeing to the higher interest rate.

I think there is a very real possibility that someone at the bank made a serious mistake. It may or may not get caught. But if they catch it quickly, there are laws that require an accountholder to return money that was paid or credited to them in error.

If it was me, I might stick it into a short-term certificate of deposit...

What's the difference in the monthly payment, when comparing the two interest rates?

BMK

[jimfrombx]

I am wondering if the loan was sold into some mortgage package and the Bank is not able to lower the interest rate as they no longer own it.. As they realized they may have a legal problem they decided to upfront the amount ot interest that "would be overcharged" to the client. The Bank , as servicer, will probably report interest as received and it would be up to the client to treat it as, for lack of a better term, OID in reverse.

[Burke]

You may be right. I do not believe this should be taxable income either. I would immediately try to refinance using this money as principal to reduce the mortgage so that you will not have to deal with this adjustment/calculation for the rest of the life of the loan, if that winds up being the case.

[JohnH]

I was thinking along the lines of using it to reduce principal, either through a refi or simply as a direct principal reduction.

The refi would provide the benefit of a lower payment if the loan term remains the same, and maybe even a lower rate, but there would be transaction costs which typically take 3-5 years to recover.

A direct principal reduction on an existing loan has the same net result as a refi to a shorter term, assuming there is no significant change in the rate, and it has the added benefit of there being no transaction costs.

Of course, all this is assuming the $63k is not taxable. If it is, then they would want to at least hold out enough to cover the taxes on the transaction.