Lisa Milkovich v. United States

FOR PUBLICATION

UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT

LISA MILKOVICH; DANG NGUYEN, No. 19-35582
Plaintiffs-Appellants,
D.C. No.
v. 2:18-cv-01658-
BJR
UNITED STATES OF AMERICA,
Defendant-Appellee. OPINION

Appeal from the United States District Court
for the Western District of Washington
Barbara Jacobs Rothstein, District Judge, Presiding

Submitted September 1, 2020
Submission Vacated October 6, 2020
Argued and Submitted November 3, 2020
Seattle, Washington

Filed March 2, 2022

Before: Jay S. Bybee and Daniel P. Collins, Circuit Judges,
and Richard G. Stearns, * District Judge.

Opinion by Judge Collins;
Dissent by Judge Stearns

*
The Honorable Richard G. Stearns, United States District Judge
for the District of Massachusetts, sitting by designation.
2 MILKOVICH V. UNITED STATES

SUMMARY **

Tax

The panel reversed the district court’s dismissal, under
Federal Rule of Procedure 12(b)(6), of a complaint by
taxpayers in a tax refund action in which they sought to
deduct mortgage interest that their lender received at the
short sale of taxpayer’s home.

Taxpayers took out a mortgage in connection with
purchasing a home, and eventually filed for bankruptcy.
When the bankruptcy petition was discharged, their
mortgage loan changed from “recourse” to “nonrecourse.”
This eliminated CitiMortgage’s pre-existing ability to
enforce the mortgage debt personally against taxpayers, and
instead limited CitiMortgage to enforcing only the value of
its lien. CitiMortgage received about $522,015 from the
short sale of the house, credited $114,688 of it toward the
accumulated unpaid interest on the secured loan, and
credited the remaining amount toward paying off the loan
principal. Taxpayers claimed a $114,688 mortgage interest
deduction for that year. The Internal Revenue Service
disallowed the deduction under I.R.C. § 265(a)(1).

The panel held that, on the facts as pleaded, taxpayers
are entitled to deduct the mortgage interest. The panel held
that the district court erred in extending the principles of
Estate of Franklin v. Commissioner, 544 F.2d 1045 (9th Cir.
1976) to short sales involving mortgages that were valid ab
initio. The panel further held that the fact that taxpayers’

**
This summary constitutes no part of the opinion of the court. It
has been prepared by court staff for the convenience of the reader.
 MILKOVICH V. UNITED STATES 3

mortgage had been converted, through the bankruptcy
discharge, from recourse to nonrecourse provides no basis
for declining the deduction and applying the settled rules for
a short sale and extinguishment of nonrecourse debt under
the approach set forth in Commissioner v. Tufts, 461 U.S.
300 (1983).

Judge Stearns dissented because he was persuaded that
the majority opinion is based on a flawed factual premise and
misreading of the applicable law. Judge Stearns disagrees
that taxpayers “paid” the mortgage interest for which they
sought a tax deduction. Judge Stearns also believes that the
majority’s legal reasoning is in error and contrary to Circuit
precedent.

COUNSEL

Kenneth C. Weil (argued), Law Office of Kenneth C. Weil,
Seattle, Washington, for Plaintiffs-Appellants.

Rachel Ida Wollitzer (argued) and Joan I. Oppenheimer,
Attorneys, Tax Division/Appellate Section; Richard E.
Zuckerman, Principal Deputy Assistant Attorney General;
United States Department of Justice, Washington, D.C.
4 MILKOVICH V. UNITED STATES

OPINION

COLLINS, Circuit Judge:

Plaintiffs Lisa Milkovich and her husband Dang Nguyen
appeal from the district court’s dismissal of their complaint
seeking a refund of additional taxes they paid after the
Internal Revenue Service (“IRS”) disallowed the deduction
they had claimed for the mortgage interest that their lender
received at the short sale of their home. Concluding that, on
the facts as pleaded, Plaintiffs were entitled to the deduction,
we reverse.

I

A

In 2005, Plaintiffs purchased a home in Renton,
Washington for $748,425, and they took out a mortgage in
connection with that purchase. 1 The complaint does not
disclose the original value of that mortgage, but a year later
Plaintiffs refinanced that loan. The new mortgage had a
principal amount of $744,993, and the mortgage was
ultimately held by CitiMortgage. Several years later,
Plaintiffs became unable to continue making their monthly
payments of $3,724.94, and they made their last such
monthly payment in February 2009.

1
Because this action was dismissed at the pleading stage, the well-
pleaded factual allegations in Plaintiffs’ complaint must be taken true.
Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009). “Review is generally
limited to the face of the complaint, materials incorporated into the
complaint by reference, and matters of judicial notice.” Stoyas v.
Toshiba Corp., 896 F.3d 933, 938 (9th Cir. 2018) (simplified).
 MILKOVICH V. UNITED STATES 5

Plaintiffs jointly filed for Chapter 7 bankruptcy in
January 2010. In the schedules filed with their bankruptcy
petition, Plaintiffs reported that their home had an
approximate 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. Indeed, after examining
Plaintiffs’ financial affairs, the bankruptcy trustee promptly
reported to the bankruptcy court that “there is no property
available for distribution from the estate over and above that
exempted by law” and that he was abandoning 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. See Mason v. Commissioner, 646 F.2d 1309,
1310 (9th Cir. 1980) (noting that, upon abandonment, “any
title that was vested in the trustee is extinguished, and the
title reverts to the bankrupt, nunc pro tunc”).

In April 2010, Plaintiffs received a discharge from the
bankruptcy court. The parties agree that this discharge
changed Plaintiffs’ mortgage from “recourse” to
“nonrecourse”—that is, it eliminated the pre-existing ability
of CitiMortgage to enforce the mortgage debt personally
against Plaintiffs and instead limited CitiMortgage to
enforcing only the value of its lien. See Johnson v. Home
State Bank, 501 U.S. 78, 84 (1991) (“[A] bankruptcy
discharge extinguishes only one mode of enforcing a
claim—namely, an action against the debtor in personam—
while leaving intact another—namely, an action against the
debtor in rem.”). Plaintiffs were thus relieved of personal
liability on the mortgage debt, but the loan owed to
CitiMortgage continued to be secured by the property and
Plaintiffs’ payment schedule (if they wished to avoid
foreclosure) was unaffected by the discharge. See Dewsnup
v. Timm, 502 U.S. 410, 417 (1992) (noting that a secured lien
6 MILKOVICH V. UNITED STATES

survives bankruptcy and “stays with the real property until
the foreclosure,” even if the value appreciates); see also
Johnson, 501 U.S. at 83 (“[A] creditor’s right to foreclose on
the mortgage survives or passes through the bankruptcy.”).

Rather than foreclose on the property, CitiMortgage
eventually agreed to a “short sale,” which took place in July
2011. “A short sale is a real estate transaction 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.” Shaw v. Experian Info.
Sols., Inc., 891 F.3d 749, 752 (9th Cir. 2018). The sale price
of the residence at the short sale was approximately
$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, while the remaining amount was credited
toward paying off the loan principal. CitiMortgage then
issued a Form 1098-Mortgage Interest Statement (“Form
1098-MIS”) for 2011 indicating that it had received
$114,688 in interest payments from Plaintiffs. Based on that
statement, Plaintiffs claimed a $114,688 mortgage interest
deduction that year.

B

In October 2014, the IRS issued a notice of deficiency,
stating that the IRS intended to disallow the $114,688
interest deduction on the ground that Plaintiffs “did not
establish that the amount . . . was (a) interest expense, and
(b) paid.” Because, however, the IRS mailed the notice to
the Renton home that Plaintiffs had sold at the 2011 short
sale, Plaintiffs never received or responded to it. Given
Plaintiffs’ lack of response, the IRS disallowed the interest
deduction and assessed additional tax due.
 MILKOVICH V. UNITED STATES 7

After Plaintiffs later learned of the IRS’s action, they
pursued various administrative remedies, but in May 2018,
the IRS Appeals Office denied Plaintiffs’ requests for relief.
In doing so, the IRS explained 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.” “[B]ecause
[Plaintiffs] have unrecognized income from forgiveness of
debt in excess of the accrued interest,” the IRS stated, they
“have no loss of income from that interest.” The IRS
therefore concluded that the interest deduction was properly
disallowed under I.R.C. § 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.” That limitation on deductions applied here,
according to the IRS, because the asserted cancellation-of-
debt income that occurred at the short sale was exempt from
income taxes “due to being non-recourse.”

Plaintiffs paid the tax assessed and filed a claim for a
refund with the IRS. After the IRS did not respond within
six months, Plaintiffs filed this civil action seeking a refund
under 28 U.S.C. § 1346(a)(1) and 26 U.S.C. §§ 6532(a)(1),
7422(a). The district court, however, granted the IRS’s
motion to dismiss Plaintiffs’ complaint pursuant to Federal
Rule of Civil Procedure 12(b)(6).

In dismissing the action, the district court did not rely on
the § 265-based rationale that the IRS had invoked in its
earlier response to Plaintiffs. Instead, the court 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
8 MILKOVICH V. UNITED STATES

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 to well below the mortgage
balance, the district court concluded that the “transaction”
lacked economic substance and that therefore any interest
deduction relating to that transaction was barred.

Plaintiffs timely appealed the district court’s judgment.
We have jurisdiction pursuant to 28 U.S.C. § 1291, and we
review the motion to dismiss de novo. Wells Fargo Bank,
N.A. v. Mahogany Meadows Ave. Tr., 979 F.3d 1209, 1213
(9th Cir. 2020).

II

We hold that, on the facts as pleaded, Plaintiffs are
entitled to deduct the mortgage interest paid in connection
with the short sale of their home in 2011.

A

As noted earlier, the district court rested its dismissal on
the view that, under Estate of Franklin, Plaintiffs’
underwater nonrecourse mortgage did not constitute a
genuine indebtedness that could support a mortgage interest
deduction. We conclude that the district court erred in
extending the principles of Estate of Franklin to short sales
involving mortgages that were valid ab initio.
 MILKOVICH V. UNITED STATES 9

In Estate of Franklin, we concluded that a partnership’s
purported debt-financed “purchase” of a motel and related
property lacked economic substance and therefore did not
give rise either to genuine indebtedness that would be “able
to support an interest deduction” or to an “investment in the
property” that would support deductions for depreciation.
544 F.2d at 1049 (emphasis omitted). In reaching this
conclusion, we relied on a number of features of the relevant
transaction. In particular, we noted that the property was
purchased at an apparently inflated price that exceeded “a
demonstrably reasonable estimate of the fair market value.”
Id. at 1048. Moreover, although $75,000 in “prepaid
interest” was paid up front by the partnership, thereafter the
partnership effectively did not have to make any further
payments for 10 years: although principal and interest
payments were due each month, those payments were set at
an amount that closely approximated the monthly lease
payments due from the “seller,” who retained possession of
the motel pursuant to a lease-back arrangement. Id. at 1046–
47. In addition, because the loan securing the purported sale
of the property was nonrecourse, the partnership had the
ability, when a “balloon” payment came due in 10 years, to
“walk away from the transaction and merely lose its $75,000
‘prepaid interest payment.’” Id. at 1047. And because, from
the outset, the purchase price exceeded the fair market value
of the property, the modest payments of principal yielded no
equity. Id. at 1048. On top of all this, no deed was ever
recorded, and the “‘benefits and burdens of ownership’
appeared to remain” with the sellers. Id. at 1047.

On these facts, we held in Estate of Franklin that the
purchase lacked “the substance necessary to justify treating
the transaction as a sale ab initio.” 544 F.2d at 1048. The
structure of the transaction confirmed that, “in accordance
with the design of the parties,” any “payments of the
10 MILKOVICH V. UNITED STATES

purchase price” would not yield any “equity to the
purchaser.” Id. at 1049 (emphasis added). And given that,
from the outset, the nonrecourse “debt” secured by the
property exceeded the property’s fair market value and no
meaningful payments were required for 10 years, there was
no genuine indebtedness, but rather only a “mere chance that
a genuine debt obligation may arise.” Id. Lacking economic
substance, the transaction could not support either
depreciation deductions or interest deductions. Id.

We expressly stated, however, that our holding was
“limited to transactions substantially similar to that now
before us.” Id. In particular, we reaffirmed the ordinary rule
that “the absence of personal liability for the purchase
money debt secured by a mortgage on the acquired property
does not deprive the debt of its character as a bona fide debt
obligation able to support an interest deduction.” Id. We
likewise explicitly distinguished cases in which “the
purchase price was at least approximately equivalent to the
fair market value of the property.” Id. at 1048. The
transaction before us, we emphasized, lacked the economic
substance necessary to characterize it “as a sale ab initio.”
Id.

Given the careful limitations that we placed on our
reasoning and holding in Estate of Franklin, the district court
erred in extending them to the very different circumstances
presented here. In Estate of Franklin, we placed dispositive
weight on the fact that, from the outset, the distinctive
arrangements of the transaction were coupled with a
“purchase price” that “exceed[ed] a demonstrably
reasonable estimate of the fair market value.” Id. at 1048;
see also id. at 1046 n.1 (observing that, “the fundamental
issue” in such cases “generally will be whether the property
has been ‘acquired’ at an artificially high price, having little
 MILKOVICH V. UNITED STATES 11

relation to its fair market value”). Here, of course, there is
no suggestion that Plaintiffs acquired their original
mortgage (or their refinanced mortgage) in a transaction that
lacked economic substance. On the contrary, on the facts as
pleaded here, the mortgage-financed purchase of Plaintiffs’
home was a valid “sale ab initio,” and neither that
transaction nor their subsequent refinancing lacked
economic substance. Id. at 1048; cf. also Beck v.
Commissioner, 678 F.2d 818, 820 (9th Cir. 1982) (applying
Estate of Franklin to transaction in which the $1,008,000
largely debt-financed purchase price exceeded the
property’s fair market value by nearly $800,000). Nothing
in Estate of Franklin suggests that, without more, a
subsequent collapse in real estate values means that the now-
underwater mortgage should be considered a sham debt that
cannot support a mortgage interest deduction. Similarly, the
fact that Plaintiffs’ mortgage became nonrecourse (as a
consequence of their bankruptcy) “does not deprive the debt
of its character as a bona fide debt obligation able to support
an interest deduction.” Estate of Franklin, 544 F.2d
at 1049. 2 And, unlike in Estate of Franklin, Plaintiffs
remained the legal owners, with actual possession of the
property, until it was sold at the 2011 short sale. Id. at 1047.3

2
As noted below, we do not have before us a situation in which the
loan was altered in a subsequent transaction that entailed a “significant
modification” of the loan for tax purposes. See infra at 22–25. We
express no view as to whether a different result would be warranted in
such a case.

3
The abandonment of Plaintiffs’ residence by the bankruptcy
trustee, and the subsequent discharge of Plaintiffs’ personal liability on
the mortgage, did not convey legal title of that property to CitiMortgage.
See Mason, 646 F.2d at 1310.
12 MILKOVICH V. UNITED STATES

Accordingly, we conclude that the district court erred in
applying Estate of Franklin to the very different
circumstances presented here.

B

We reject the IRS’s alternative argument that I.R.C.
§ 265(a)(1) precludes Plaintiffs’ home mortgage interest
deduction. Our analysis of this issue proceeds in two steps.
First, where (as here) a short sale involves nonrecourse debt,
the transaction does not give rise to cancellation-of-debt
income that might trigger the application of § 265. Second,
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.

1

Under the analysis set forth in the Tax Court’s decision
in Catalano v. Commissioner, T.C. Memo. 2000-82, rev’d
on other grounds, 279 F.3d 682 (9th Cir. 2002), the result in
this case would be straightforward if Plaintiffs’ debt had
been nonrecourse from its inception. 4 Catalano started from
the premise that a short sale or foreclosure involving
nonrecourse debt is treated as a single transaction in which
any loan forgiveness is folded into the debtor’s “gain or loss”
in the sale of the property. Id. at *3. Catalano then
concluded that, when the amount realized by the debtor in
such a sale or foreclosure includes “both principal and
accrued interest,” the debtor “is appropriately deemed to

4
Although Tax Court memorandum decisions are not precedential,
see InverWorld, Ltd. v. Commissioner, 979 F.2d 868, 878 n.9 (D.C. Cir.
1992), we find the analysis in Catalano to be instructive.
 MILKOVICH V. UNITED STATES 13

have paid the interest in the disposition of his residence” and
“is entitled to the interest deduction” associated with that
payment. Id. at *4 (emphasis added). Both aspects of
Catalano’s analysis are consistent with settled law, and we
follow a similar analysis here.

a

The law is clear that a short sale or foreclosure involving
nonrecourse debt may give rise to income “derived from
dealings in property” under I.R.C. § 61(a)(3), but it does not
give rise to income “from discharge of indebtedness” under
I.R.C. § 61(a)(11).

As a general matter, a “repossession of property securing
a debt constitutes a taxable sale or exchange.” Estate of
Delman v. Commissioner, 73 T.C. 15, 28 (1979). Moreover,
the Supreme Court has held that, under Crane v.
Commissioner, 331 U.S. 1 (1947), “[w]hen a taxpayer sells
or disposes of property encumbered by a nonrecourse
obligation,” he or she must “include among the assets
realized the outstanding amount of the obligation.”
Commissioner v. Tufts, 461 U.S. 300, 317 (1983) (emphasis
added). This same rule applies even “when the unpaid
amount of the nonrecourse mortgage exceeds the value of
the property transferred.” Id. at 307. If the result of the short
sale, and its accompanying extinguishment of nonrecourse
debt, is that the taxpayer realizes a “gain” on the sale, then
the taxpayer may realize taxable income “derived from
dealings in property” under I.R.C. § 61(a)(3). See
2925 Briarpark Ltd. v. Commissioner, 163 F.3d 313, 318
(5th Cir. 1999) (“Section 61(a)(3) applies when a taxpayer
agrees to surrender the property in exchange for the
cancellation of a [nonrecourse] debt,” with “the whole
amount of the canceled nonrecourse indebtedness being
includable in the amount realized under [I.R.C.] § 1001.”);
14 MILKOVICH V. UNITED STATES

see also I.R.C. § 1001 (providing rules for calculation of
gain or loss on a “sale or other disposition of property”).
Any such “income realization is not based on cancellation of
indebtedness.” Estate of Delman, 73 T.C. at 33 (emphasis
added).

The facts of Tufts illustrate how these principles work.
In Tufts, a partnership took out a $1,851,500 nonrecourse
mortgage to finance the construction of an apartment
complex. Id. at 302. After the complex was completed, the
property’s fair market value fell to $1,400,000, and the
partners sold their interests in the property to a third party
for almost no consideration other than that party’s
assumption of the nonrecourse loan. Id. at 303. At the time
of the sale, the partnership’s adjusted basis in the property
was $1,455,740. Id. at 302. Because the property’s fair
market value of $1,400,000 on the day of the sale was less
than this adjusted basis, the partners claimed a partnership
loss of $55,740. Id. at 303. The Commissioner disagreed,
arguing that the partnership had realized a gain of
approximately $400,000 because, in the sale of the property,
the partnership “had realized the full amount of the
nonrecourse obligation,” which was over $1,800,000. Id.
The Supreme Court agreed, holding that the Commissioner
properly included, “in the amount realized” on the sale, “the
amount of the nonrecourse mortgage assumed by the
purchaser.” Id. at 309. Although the facts of Tufts involved
the assumption of a nonrecourse mortgage rather than its
cancellation, there is no reason why its analysis would not
apply in the latter context. Under Tufts, therefore, a
cancellation of a nonrecourse loan in a short sale or
foreclosure gives rise to income derived from dealings in
property, rather than income from discharge of indebtedness.
 MILKOVICH V. UNITED STATES 15

The analysis is different, however, when there is a short
sale or foreclosure involving recourse debt. “With a
recourse debt, a debtor remains liable for the unpaid balance
after a foreclosure sale.” 2925 Briarpark, Ltd., 163 F.3d
at 318 n.2. Therefore, unlike the situation with a
nonrecourse debt (in which the foreclosure on the deed of
trust itself eliminates the only means to collect on the debt),
some additional action, beyond the transfer of the property,
is required to eliminate the otherwise surviving personal
liability associated with recourse debt. Consequently, a
foreclosure involving the forgiveness of recourse debt, for
tax purposes, is split into two transactions: (1) the transfer of
the property itself—a transaction in which “the unpaid
portion [of the loan] is not used to calculate ‘amount
realized’” on the sale or exchange, id. (emphasis added)
(citation omitted); and (2) a forgiveness of the surviving
individual liability, which gives rise to “discharge of
indebtedness” income under I.R.C. § 61(a)(11). See Treas.
Reg. § 1.1001-2(c), Ex. 8; see also id. § 1.1001-2(a)(2)
(“The amount realized on a sale or other disposition of
property that secures a recourse liability does not include
amounts that are . . . income from the discharge of
indebtedness.”). 5

The Tax Court’s decision in Simonsen v. Commissioner,
150 T.C. 201 (2018), further confirms the settled rules
governing short sales involving nonrecourse encumbrances.
In Simonsen, the taxpayers successfully negotiated a short

5
In her concurrence in Tufts, Justice O’Connor argued that, if the
Court were writing on a clean slate, it might make sense to separate into
two transactions a sale of property encumbered by a nonrecourse
mortgage that exceeds the property’s value. 461 U.S. at 317–19. But
given that the IRS regulations and lower-court caselaw had long taken a
different approach, she agreed with the Court’s decision not to adopt
such a change judicially. Id. at 319.
16 MILKOVICH V. UNITED STATES

sale when, after the 2008 financial crisis, their existing
nonrecourse mortgage debt greatly exceeded their home’s
fair market value. Id. at 201–02. Unlike in the present case,
the taxpayers in Simonson would have benefitted from
splitting the short sale into two transactions, and they
therefore argued that “the sale and consequent debt
forgiveness” should be treated as “two separate transactions
that resulted in both [1] a substantial deductible loss [on the
sale] and [2] excludable cancellation-of-indebtedness (COI)
income.” Id. at 202. The IRS disagreed, arguing that the
law was clear that the short sale is treated as “one transaction
and the discharged debt is included in the amount realized
on the sale.” Id. The Tax Court agreed with the IRS,
concluding that “[t]here was but one transaction” and that its
tax treatment was dictated by Tufts. Id. at 211–12. The Tax
Court held that the IRS thus correctly included “the debt
discharged . . . in the amount realized” on the sale, and the
resulting income was properly classified as “‘[g]ains derived
from dealings in property’ under section 61(a)(3).” Id.
at 206–07; see also id. at 213 (“This means that we have to
apply the rules for computing gain or loss on a sale and not
the rules for calculating the amount of COI income.”). 6

Accordingly, because Plaintiffs’ short sale here involved
the extinguishing of nonrecourse debt, it did not generate
cancellation-of-indebtedness income within the meaning of
I.R.C. § 61(a)(11). The transaction instead must be
evaluated under Tufts as a single transaction that may
produce “[g]ains derived from dealings in property.” I.R.C.

6
Simonsen thus refutes the dissent’s suggestion that Tufts “applies
only when the taxpayer retains an ownership interest in the property”
after the transaction and therefore does not apply to a short sale in which
“any remaining interest [the mortgagors] had held in the property
dissolved with the sale of the property.” See Dissent at 32, 33.
 MILKOVICH V. UNITED STATES 17

§ 61(a)(3). Plaintiffs contend that, applying that approach
here, the short sale in this case produced a nondeductible
loss, rather than a gain. The IRS’s brief in this court has not
disputed that particular point, and we therefore take the point
as conceded for purposes of this appeal. 7 Accordingly,
under the settled rules that are applicable to a short sale
involving nonrecourse debt, Plaintiffs’ sale did not generate
any taxable income.

b

The next question is whether—again applying the
normal rules that govern short sales concerning nonrecourse
debt—Plaintiffs were entitled to deduct the mortgage
interest that CitiMortgage received at the short sale. We
conclude that the answer is yes—Plaintiffs paid the interest
in question, and the interest payment is deductible.

The case before us is in this respect analogous to
Catalano. There, the Tax Court first concluded that the San
Francisco residence at issue had been abandoned to the
debtor during his bankruptcy proceedings. T.C. Memo.
2000-82, at *3. The property was encumbered by a
mortgage held by Wells Fargo, which “was either
nonrecourse or treated as nonrecourse under California law.”
Id. When the home was subsequently sold at a foreclosure,
there was an outstanding principal balance of $1,341,352 on
that mortgage, and the residence was sold at the foreclosure
sale for $1,215,000. Id. at *2. The debtor sought to take a
deduction for mortgage interest paid to Wells Fargo in

7
Instead, the IRS suggests that the earlier shift of Plaintiffs’ loan
from recourse to nonrecourse during the bankruptcy proceedings has the
effect of rendering the standard Tufts analysis inapplicable. This
argument is wrong for reasons explained below. See infra at 21–27.
18 MILKOVICH V. UNITED STATES

connection with the short sale, but the IRS disallowed the
deduction on the ground that the fair market value of the
residence was less than the outstanding mortgage principal.
Id. at *3. The Tax Court concluded that, under Tufts, it was
irrelevant what the fair market value of the house was at the
time of the foreclosure sale. Id. Instead, under Tufts, the
amount that the debtor “realized upon the disposition of his
residence in foreclosure included both the principal
indebtedness and the interest that had accrued as of the
foreclosure date.” Id.; see also Allan v. Commissioner,
856 F.2d 1169, 1171–72 (8th Cir. 1988). Consequently, the
Tax Court concluded, the debtor “is appropriately deemed to
have paid the interest in the disposition of his residence,” and
he was therefore “entitled to the interest deduction here.” Id.
at *4. 8

The same result follows here. When, as in this case,
nonrecourse liability “is extinguished in exchange for an
asset, ‘the transaction is treated as if the transferor had sold
the asset for cash equivalent to the amount of the debt and
had applied the cash to the payment of the debt.’” Catalano,
T.C. Memo. 2000-82 at *4 (quoting Unique Art Mfg. Co. v.
Commissioner, 8 T.C. 1341, 1342 (1947)). Here,
CitiMortgage received approximately $522,000 from the
short sale. CitiMortgage applied $114,688 of that payment
to interest, consistent with Treas. Reg. § 1.446-2(e)(1) (and,
presumably, in accordance with the terms of its deed of

8
On appeal in Catalano, we reversed the Tax Court’s threshold
determination that there had been an abandonment of the property by the
bankruptcy trustee, and we therefore had no occasion to address whether
the Tax Court’s analysis based on that determination was otherwise
correct. See 279 F.3d at 687–88. Here, by contrast, it is undisputed that
the bankruptcy trustee abandoned Plaintiffs’ residence, and Catalano’s
analysis of the tax consequences of such an abandonment, and a
subsequent short sale, is therefore instructive here.
 MILKOVICH V. UNITED STATES 19

trust), and it reported that amount as interest received on a
Form 1098-MIS. Applying payments to interest first is the
long-established default rule in federal and Washington law.
See Story v. Livingston, 38 U.S. 359, 371 (1839) (“The
correct rule, in general, is, that the creditor shall calculate
interest, whenever a payment is made. To this interest, the
payment is first to be applied; and if it exceed the interest
due, the balance is to be applied to diminish the principal. If
the payment fall short of the interest, the balance of interest
is not to be added to the principal so as to produce interest.”);
Clausing v. Virginia Lee Homes, Inc., 384 P.2d 644, 647
(Wash. 1963) (“Installment payments are applied first to
payment of interest and the remainder, if any, applied to
payment of principal.”). Plaintiffs therefore must be deemed
to be the persons who paid that mortgage interest to
CitiMortgage. See also Treas. Reg. § 1.446-2(e)(1) (stating
the general rule that, when a taxpayer makes a payment on a
loan that consists of both accrued interest and principal,
“each payment under [the] loan . . . is treated as a payment
of interest to the extent of the accrued and unpaid interest
. . . .”). Moreover, because, under Tufts, Plaintiffs are
deemed at the short sale to have realized an amount that
includes all of the discharged nonrecourse debt, including
the accrued interest, see Allan, 856 F.2d at 1172–73;
Catalano, T.C. Memo. 200-82 at *4, 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). 9

9
The dissent’s contrary view is based on the premise that, because
Plaintiffs “had long ago pledged any sale proceeds to CitiMortgage by
deed of trust,” their home was “an asset belonging wholly to another (in
this case CitiMortgage),” and therefore the interest payment received by
20 MILKOVICH V. UNITED STATES

In contending that Plaintiffs did not make the interest
payment here, the IRS argues that Crane’s rule that debtors
realize a benefit from, and therefore have a corresponding
interest in, the full amount of nonrecourse debt discharged at
a sale should not apply here because, “‘if the value of the
property is less than the amount of the mortgage, a
mortgagor who is not personally liable cannot realize a
benefit equal to the mortgage’” (quoting Crane, 331 U.S. at
14 n.37). This argument is plainly wrong, because it
attempts to distinguish Crane on grounds that were expressly
rejected in Tufts. As the Court in Tufts explained after
quoting that very footnote from Crane: “This case presents
that unresolved issue. We are disinclined to overrule Crane,
and we conclude that the same rule applies when the unpaid
amount of the nonrecourse mortgage exceeds the value of

CitiMortgage at the short sale was one that CitiMortgage “alone
generated.” See Dissent at 31, 34. No authority supports the dissent’s
novel view that owners of homes with underwater mortgages do not
really own their homes at all. On the contrary, unless and until the house
is sold or foreclosed on, homeowners have a continued ownership
interest in their residence and could, for example, benefit from any
unexpected rally in the price of the home. Cf. Allan, 856 F.2d at 1173
(“[T]here is no doubt that had the Apartment recovered financially, the
Partnership would have been legally obligated to repay the entire
outstanding principal amount of the mortgage, including . . . the interest
thereon.”); cf. also Alsberg v. Robertson (In re Alsberg), 68 F.3d 312,
313–14 (9th Cir. 1995) (noting that the value of debtors’ home rose from
$259,000 to $380,000 one year after they filed for bankruptcy, thereby
producing enough funds to pay off the mortgage in full and produce a
$115,000 profit). Moreover, the dissent’s premise that CitiMortgage
paid the interest to itself ignores Crane’s teaching that, for tax purposes,
a mortgagor may not need to have actually received the proceeds of a
sale to be deemed to have paid them over. See 331 U.S. at 13 (noting
that, in some circumstances, a seller who has not actually received funds
will be treated as having had the money “‘paid [to] it and then paid over
by it to its creditors’”) (citation omitted)).
 MILKOVICH V. UNITED STATES 21

the property transferred.” 461 U.S. at 307 (emphasis
added). 10

Accordingly, we conclude that, if the ordinary rules
applicable to a short sale involving the extinguishment of
nonrecourse debt are applied here, then Plaintiffs were
entitled to the mortgage interest deduction that they took. 11

2

The only remaining question, then, is whether a different
outcome is warranted here based on the fact that, as a result
of their 2010 bankruptcy discharge, Plaintiffs’ mortgage was
effectively converted from recourse to nonrecourse. The
IRS argues that the 2010 bankruptcy discharge’s conversion
of Plaintiffs’ mortgage to nonrecourse rendered any interest
payment at the 2011 short sale disallowable under I.R.C.

10
Notably, the IRS does not contend that the deductible interest
payment is allocable to a tax-exempt gain on the sale of Plaintiffs’
residence, see I.R.C. § 121, thereby triggering I.R.C. § 265(a)(1), which
disallows otherwise-allowable deductions that are “allocable to one or
more classes of income . . . wholly exempt from the taxes imposed by
this subtitle.” (The IRS does argue that § 265(a)(1) applies here, but only
based on Plaintiffs’ bankruptcy. We address the IRS’s bankruptcy-based
theory below. See infra at 21–27.) As noted earlier, the IRS did not
contest Plaintiffs’ assertion that there was a loss on the sale, rather than
a gain. See supra at 17.
11
The dissent argues that, if Plaintiffs are deemed to have paid the
mortgage interest that CitiMortgage received, that would create a “moral
hazard” that presents “a threat to the integrity of the Tax Code.” See
Dissent at 34. These concerns are overwrought. Our analysis avoids a
converse problem in which the Government simultaneously denies that
Plaintiffs made any interest payment to CitiMortgage at the short sale
while treating a portion of the funds received by CitiMortgage as interest
payments that are then presumptively taxable income as to CitiMortgage.
The Government, too, “cannot have it both ways.” See id.
22 MILKOVICH V. UNITED STATES

§ 265(a)(1), which provides that “[n]o deduction shall be
allowed for . . . [a]ny amount otherwise allowable as a
deduction which is allocable to one or more classes of
income . . . wholly exempt from the taxes imposed by this
subtitle.” I.R.C. § 265(a)(1). According to the IRS,
Plaintiffs’ mortgage interest deduction was precluded under
this section because (1) Plaintiffs received “income” when
their bankruptcy discharge converted their mortgage from
recourse to nonrecourse; and (2) that income was exempt
from taxation under I.R.C. § 108(a)(1)(A), which exempts
from taxable income any discharge of indebtedness that
“occurs in a title 11 case.” Neither premise of the IRS’s
argument is correct, as the plain language of the statute and
regulations makes clear.

a

The IRS is wrong in positing that the conversion of
Plaintiffs’ mortgage from recourse to nonrecourse gave rise
to otherwise taxable “income” that was then exempted from
taxation by operation of § 108(a)(1)(A). As the text of the
statute makes clear, § 108(a)(1)(A) is only triggered when
there is an “amount which (but for this subsection) would be
includible in gross income by reason of the discharge (in
whole or in part) of indebtedness of the taxpayer.” I.R.C.
§ 108(a)(1) (emphasis added). Here, however, there is no
basis for concluding that the 2010 conversion of Plaintiffs’
mortgage from recourse to nonrecourse gave rise to
“income” that “but for this subsection”—i.e., but for
§ 108(a)—would have been included in Plaintiffs’ taxable
income. On the contrary, the applicable Treasury
regulations squarely refute this contention.

A change in a debt instrument will be deemed to give rise
to a potentially taxable exchange of debt instruments only if,
inter alia, the underlying debt instrument undergoes a
 MILKOVICH V. UNITED STATES 23

“significant modification.” Treas. Reg. § 1.1001-3(b)
(emphasis added). 12 A “change (in whole or in part) in the
recourse nature of the instrument (from recourse to
nonrecourse or from nonrecourse to recourse) is a
modification.” Id. § 1.1001-3(c)(2)(i); see also id. § 1.1001-
3(c)(1)(i) (“A modification means any alteration, including
any deletion or addition, in whole or in part, of a legal right
or obligation of the issuer or a holder of a debt instrument,
whether the alteration is evidenced by an express agreement
(oral or written), conduct of the parties, or otherwise.”). A
modification, however, is generally deemed to be “a
significant modification only if, based on all facts and
circumstances, the legal rights or obligations that are altered
and the degree to which they are altered are economically
significant.” Id. § 1.1001-3(e)(1). Amplifying on that
standard, the regulations specifically address when a
conversion of a loan from recourse to nonrecourse will be
deemed to entail a “significant modification.” Id. § 1.1001-
3(e)(5)(ii). Under those rules, a “modification that changes
a recourse debt instrument to a nonrecourse debt instrument
is not a significant modification if [1] the instrument
continues to be secured only by the original collateral and
[2] the modification does not result in a change in payment
expectations.” Id. § 1.1001-3(e)(5)(ii)(B)(2).

Under the facts as pleaded, the change in Plaintiffs’
mortgage from recourse to nonrecourse does not meet the
definition of a significant modification. First, the loan
continued to be “secured only by the original collateral.”
Treas. Reg. § 1.1001-3(e)(5)(ii)(B)(2). Second, there was no

12
All citations of the Treasury regulations in this paragraph are of
the April 1, 2010 version that was in effect when Plaintiffs obtained their
bankruptcy discharge. The current regulations contain changes in
wording that are immaterial to the issues addressed here.
24 MILKOVICH V. UNITED STATES

change in payment expectations. A “change in payment
expectations occurs if, as a result of [the] transaction,” either
(1) there is “a substantial enhancement of the obligor’s
capacity to meet the payment obligations under a debt
instrument and that capacity was primarily speculative prior
to the modification and is adequate after the modification”;
or (2) there is “a substantial impairment of the obligor’s
capacity to meet the payment obligations under a debt
instrument and that capacity was adequate prior to the
modification and is primarily speculative after the
modification.” Id. § 1.1001-3(e)(4)(vi). Taking the well-
pleaded allegations in the complaint as true, there is no basis
for concluding that Plaintiffs’ capacity to meet their payment
obligations under their CitiMortgage loan was any different
before and after the bankruptcy discharge. Under the
allegations of the complaint, Plaintiffs became unable to
meet their payment obligations in early 2009 and remained
unable to do so thereafter, including after their bankruptcy
discharge. Because the modification of Plaintiffs’ loan from
recourse to nonrecourse in 2010 did not involve a
“significant modification,” it did not give rise to a potentially
taxable event.

Accordingly, the conversion of Plaintiffs’ mortgage
from recourse to nonrecourse as a result of the bankruptcy
discharge did not give rise to any income that “(but for this
subsection [108(a)]) would be includible in gross income by
reason of the discharge (in whole or in part) of
indebtedness.” I.R.C. § 108(a)(1). Thus, the IRS is incorrect
in concluding that Plaintiffs had otherwise-taxable income
from that conversion that was then exempted from taxation
by § 108(a)(1). Rather, they had no “income” from that
conversion in the first place, regardless of § 108(a)(1). For
that reason alone, § 265(a)(1) can have no application here.
See I.R.C. § 265(a)(1) (stating that its deduction
 MILKOVICH V. UNITED STATES 25

disallowance rule only applies if there is associated
“income” that is then “wholly exempt” from taxation). 13

b

There is an alternative and independent reason why
§ 265(a)(1) does not preclude Plaintiffs’ home mortgage
interest deduction. Even assuming (contrary to the reality)
that the conversion of Plaintiffs’ mortgage to nonrecourse
was a taxable event that gave rise to otherwise taxable
cancellation-of-indebtedness income, the exemption that
would then apply under § 108(a)(1)(A) does not meet
§ 265(a)(1)’s requirement that the exemption be one that
“wholly exempt[s]” that “class[] of income” from taxation.
I.R.C. § 265(a)(1).

As noted earlier, § 108(a)(1) provides that “[g]ross
income does not include any amount which (but for this
subsection) would be includible in gross income by reason
of the discharge (in whole or in part) of indebtedness of the
taxpayer if . . . (A) the discharge occurs in a title 11 case.”
However, § 108(b)(1) provides that “[t]he amount excluded
from gross income under subparagraph (A) . . . of subsection
(a)(1) shall be applied to reduce the tax attributes of the
taxpayer . . . .” Thus, for example, a taxpayer who benefits
from a § 108(a)(1)(A) exclusion of debt-cancellation income

13
The dissent implies that the “monetary gain” attributable to the
conversion of the loan from recourse to nonrecourse brings this case
within the scope of § 108 and § 265. However, these provisions require
that the assertedly tax-exempt amount otherwise count as “income,” and
the dissent has failed to explain how the “monetary gain” in this case
qualifies as “income.” See Dissent at 33. This would rewrite the plain
language of § 108 and § 265, which we may not do. Similarly, the
dissent fails to explain how the reasoning of Tufts can be distinguished
on the grounds that that case “did not involve a bankruptcy.” Id. at 33.
26 MILKOVICH V. UNITED STATES

may need to reduce the basis of his or her property by the
amount of the exclusion. See I.R.C. § 108(b)(2)(E). That,
of course, would increase the gain on a subsequent sale of
the property by a corresponding amount. The Supreme
Court has thus aptly noted that “the effect of § 108 is not
genuinely to exempt such income from taxation, but rather
to defer the payment of the tax” by, inter alia, “increasing
the size of taxable gains upon ultimate disposition of the
reduced-basis property.” United States v. Centennial Sav.
Bank FSB, 499 U.S. 573, 580 (1991); see also, e.g.,
Simonsen, 150 T.C. at 204 n.7 (“When [cancellation of
indebtedness] income is excluded, there is typically a
corresponding adjustment made somewhere so that the
Commissioner doesn’t forgo tax forever.”); Nelson v.
Commissioner, 110 T.C. 114, 125 (1998) (en banc) (“An
exclusion that is subject to an offset (the tax attribute
reductions) and may be subject to taxation in the future (that
is, excluded from gross income for the taxable year) does
not signify or indicate an item of income that is necessarily
tax exempt on a permanent basis.”), aff’d 182 F.3d 1152
(10th Cir. 1999).

It follows that cancellation-of-indebtedness income
exempted under § 108(a)(1)(A) is not “wholly exempt” from
income taxation within the meaning of § 265(a)(1). See
Cotton States Fertilizer Co. v. Commissioner, 28 T.C. 1169,
1173 (1957) (holding that the predecessor to § 265 did not
apply to an exclusion that “requires the taxpayer to decrease
the basis of the new property by the amount of the gain not
recognized by reason of its election” under a provision of the
Code addressing involuntary conversions, because the
exclusion did “not result in giving a ‘wholly exempt’
classification to income received . . . . At best, [it] provides
for the postponement of tax.”); Hawaiian Tr. Co. v. United
States, 291 F.2d 761, 773 (9th Cir. 1961) (“Wholly exempt
 MILKOVICH V. UNITED STATES 27

income is never taxed. . . . [Nonrecognized gains] may be
taxed, however, . . . at another time. In other words, [they]
are not ‘wholly exempt’ from the tax.”).

The IRS argues that Plaintiffs have not offset their tax
attributes under § 108(b), but the plain language of
§ 265(a)(1) requires that the relevant exemption be one that
“wholly exempt[s]” a “class[ ] of income” from income
taxation, not merely one that “exempts” income from
taxation. I.R.C. § 265(a)(1) (emphasis added). For the
reasons set forth above, § 108(a)(1)(A) does not meet that
standard here and it therefore provides no basis for applying
§ 265(a)(1).

III

In sum, Plaintiffs’ home mortgage interest deduction is
not precluded by Estate of Franklin. Moreover, under the
settled rules for a short sale involving the extinguishment of
nonrecourse debt, the Tufts approach applies, and Plaintiffs
were entitled to take the corresponding mortgage interest
deduction for the interest paid and received at the short sale.
The fact that, during an earlier bankruptcy, Plaintiffs’
mortgage had been converted, through their bankruptcy
discharge, from recourse to nonrecourse, provides no basis
for declining to apply those rules.

REVERSED.
28 MILKOVICH V. UNITED STATES

STEARNS, District Judge, dissenting:

Because I am persuaded that the majority opinion is
based on a fictional factual premise and a misreading of the
applicable law, I respectfully dissent. The flawed factual
premise is this: It is simply not the case, as the majority
asserts, that appellants Lisa Milkovich and Dang Nguyen
“paid” the mortgage interest for which they sought a tax
deduction, and no amount of “deeming” it so can make it
otherwise. See Majority op. at 19. I also believe that the
majority’s rejection of the sound reasoning of the Internal
Revenue Service (IRS), relying on a twenty-year-old
nonprecedential (and never since cited as authority) Tax
Court memorandum decision, Catalano v. Comm’r, T.C.
Memo. 200-82, rev’d, 279 F.3d 682 (9th Cir. 2002), is in
error and contrary to precedent in this Circuit.

Let me begin with where I agree with the majority. The
essential facts are not in dispute. In 2005, Milkovich and
Nguyen purchased a home in the State of Washington for
$748,425. The purchase price reflected the fair market value
of the home at the time. The couple refinanced the mortgage
with Westwood Mortgage (later CitiMortgage) in 2006 for
$744,993. Milkovich and Nguyen agreed to interest-only,
monthly payments of $3,724.94. They stopped making the
mortgage payments in February of 2009 and filed for
bankruptcy on January 25, 2010.

The bankruptcy trustee abandoned the home on March 4,
2010, after determining it irretrievably under water. As a
result of the discharge of the quasi-judicial lien, title to the
property revested in Milkovich and Nguyen. See Jack F.
 MILKOVICH V. UNITED STATES 29

Williams, The Tax Consequences of Abandonment under the
Bankruptcy Code, 67 Temp. L. Rev. 13, 30, 36 (1994). 1

In April of 2010, Milkovich and Nguyen received a
bankruptcy discharge. On July 21, 2011, the house was sold
by CitiMortgage in a short sale for $550,000, from which
CitiMortgage received $522,015. Of that amount, $114,688
was allocated to the payment of the outstanding interest on
the $744,993 loan. See 26 C.F.R. § 1.446-2(e)(1).
Subsequently, CitiMortgage sent Milkovich and Nguyen a
Form 1098-MIS for the tax year 2011, which reported the
receipt of $114,688 in mortgage interest from the couple. 2
As cash-basis taxpayers, Milkovich and Nguyen claimed an
interest deduction of $114,688 on their 2011 tax bill based
on 26 U.S.C. § 163.

On October 20, 2014, the IRS sent a notice of deficiency
to Milkovich and Nguyen at the address of their former home
proposing to disallow the couple’s $114,688 interest
1
The trustee’s abandonment of the property had no tax
consequences independent of the conversion of Milkovich and Nguyen’s
debt from recourse to nonrecourse. “Under tax law, abandonment is the
equivalent of a sale or exchange . . . . [B]ankruptcy abandonment[,
however,] is an entirely different species . . . best viewed as a disclaimer
of interest in estate property by a trustee as the representative of the
estate. The rights and responsibilities that existed in the property
immediately before the bankruptcy filing remain with the debtor
throughout the administration of the case, subject to the trustee’s judicial
lien power. . . . The effect of a trustee’s release of its judicial lien is to
divest control over the abandoned asset, . . . [thus] bankruptcy
abandonment is not a transfer or exchange for tax purposes any more
than the release of a judicial lien is a transfer or exchange.” Williams,
supra, 67 Temp. L. Rev. at 35–36; see also In re Olson, 930 F.2d 6, 8
(8th Cir. 1991) (per curiam).
2
There is no explanation in the record as to why CitiMortgage
mailed the Form-1098-MIS to the appellants.
30 MILKOVICH V. UNITED STATES

deduction. Because Milkovich and Nguyen no longer lived
at the address, they did not receive the notice and did not
respond. The IRS disallowed the deduction in March of
2015 and assessed an additional tax due. After a failed effort
to persuade the tax examiner to reconsider the disallowance,
Milkovich and Nguyen appealed. In May of 2018, the IRS
appeals office upheld the disallowance, citing to Internal
Revenue Code (IRC) § 265 and Regs. 1.265-1, which
“prohibit the deduction of expenses related to tax-exempt
income.” Milkovich and Nguyen paid the outstanding tax
liability and then filed this lawsuit in the district court.

The district court granted the government’s Rule
12(b)(6) motion to dismiss in May of 2019. Relying on
Estate of Franklin v. Comm’r, 544 F.2d 1045 (9th Cir. 1976),
the court held that because the underlying transaction lacked
“economic substance,” it fell “squarely” within Franklin’s
sham transaction tax avoidance rule. Milkovich v. United
States, No. 2:18-CV-01658-BJR, 2019 WL 2161665, at *2
(W.D. Wash. May 17, 2019), quoting Franklin, 544 F.2d at
1049.

I fully agree with the thorough explanation set out in Part
IIA of the majority opinion as to why the district court’s
reliance on Franklin was misplaced. I also agree with so
much of Part IIB that explicates the differences between
recourse and nonrecourse debt. I disagree, however, that
Catalano’s holding―that a nonrecourse debtor whose
property interest is liquidated at a short sale or foreclosure is
entitled to deduct so much of the proceeds as is allocated to
interest―is “consistent with settled law.” Majority Op.
at 13. It is not.

The IRC provides that a taxpayer may deduct “all
interest paid or accrued within the taxable year on
indebtedness.” 26 U.S.C. § 163(a). However, “[t]o justify
 MILKOVICH V. UNITED STATES 31

an interest deduction [under section 163(a)], a taxpayer must
actually pay for the use or forbearance of money.” Beck v.
Comm’r, 678 F.2d 818, 821 (9th Cir. 1982) (emphasis
added). In the 2011 tax year for which Milkovich and
Nguyen sought to deduct mortgage interest (and during the
preceding two years), they made no mortgage interest (or
principal) payments. In other words, the interest payment
that CitiMortgage received in tax year 2011 was one that it
alone generated through the short sale (and one that it by law
was required to report for tax purposes as corporate income).
Compare Golder v. Comm’r, 604 F.2d 34, 36 (9th Cir. 1979)
(noting that in a situation where a taxpayer seeks to deduct
interest payments on “a non-recourse note secured by a
mortgage on the land . . . [t]he taxpayer [still] must pay the
interest to avoid foreclosure of his ownership interest in the
property.”) (emphasis added).

The IRC provides that “[n]o [tax] deduction shall be
allowed for . . . [a]ny amount otherwise allowable as a
deduction which is allocable to one or more classes of
income other than interest . . . wholly exempt from the taxes
imposed by this subtitle . . . .” 26 U.S.C. § 265(a)(1).
Pursuant to I.R.C. § 108(a)(1)(A), income from a discharge
of indebtedness in a bankruptcy case is exempt from gross
income. The government does not argue that Appellants
received a discharge of indebtedness income when the short
sale closed. Rather, the government argues that prior to the
short sale, “the discharge of taxpayers’ personal liability on
the mortgage loan was excluded from gross income because
it occurred in a bankruptcy case,” Appellee Br. at 31–32, and
therefore “was exempt from taxation under I.R.C.
§ 108(a)(1)(A).” Id. at 35.

Milkovich and Nguyen counter that the transformation
of their mortgage from recourse into nonrecourse debt
32 MILKOVICH V. UNITED STATES

following the bankruptcy discharge did not result in a
discharge of indebtedness at all. This is because, they argue,
the “‘discharged debt’ was ultimately [required to be]
included in [the] amount realized on the sale of the personal
residence,” Appellants’ Reply at 16, and so was not really
“discharged” at all. Appellants’ contention relies on the
Supreme Court’s decision in Comm’r v. Tufts, 461 U.S. 300
(1983), and its holding that “[w]hen a taxpayer sells or
disposes of property encumbered by a nonrecourse
obligation, the Commissioner properly requires him to
include among the assets realized the outstanding amount of
the obligation. The fair market value of the property is
irrelevant to this calculation.” Id. at 317 (emphasis added).
Appellants contend that both I.R.C. § 108 and I.R.C.
§ 265(a)(1) are inapplicable because the bankruptcy
discharge merely deferred the tax consequences associated
with the now-nonrecourse mortgage debt to a later
stage―for example, when calculating assets realized upon
disposition of the property. As a result, they maintain that
the discharged mortgage debt did not reflect income “wholly
exempt from the taxes imposed by this subtitle.” I.R.C.
§ 265(a)(1).

What Milkovich and Nguyen’s argument omits is the
fact that Tufts’s refusal to differentiate between the tax
implications of recourse and nonrecourse debt applies only
when the taxpayer retains an ownership interest in the
property and thus stands to benefit from any future gain in
the property’s sale or disposition, or conversely, from any
capital loss. “The principal application of Section 265(a)(1)
is to bar the deduction of expenses incurred in the course of
earning tax-exempt income.” Induni v. Comm’r, 990 F.2d
53, 55 (2d Cir. 1993). In interpreting Section 265, this
Circuit has explained that “[w]holly exempt income is never
taxed” as compared to income which “may be taxed . . . at
 MILKOVICH V. UNITED STATES 33

another time.” Hawaiian Tr. Co. Ltd. v. United States,
291 F.2d 761, 773 (9th Cir. 1961).

Here, when Milkovich and Nguyen’s mortgage was
transformed from recourse debt into nonrecourse debt
through bankruptcy, they received a monetary gain that was
never taxed—that is, the discharge of personal liability on
their mortgage debt. Because of this discharge of personal
liability, appellants were not later required to report as a
taxable gain the $222,977.95 difference between the initial
value of the mortgage and the amount CitiMortgage
recouped from the short sale. Thus, the discharge of the
mortgage loan through bankruptcy resulted in a tax-exempt
discharge of indebtedness within the meaning of I.R.C.
§ 108(a)(1)(A), precluding an interest deduction under
I.R.C. § 265(a)(1). The gain (in the form of debt relief) that
Milkovich and Nguyen received through the bankruptcy
discharge would not be erased by the application of Tufts,
which would require them, as taxpayers holding nonrecourse
debt, to include that debt in calculating the amount realized
from the disposition of their former home, an imaginary
prospect given the fact that any remaining interest they had
held in the property dissolved with the sale of the property
in July of 2011. Tufts, 461 U.S. at 304. While it is true that
Tufts involved nonrecourse debt on a property in an amount
greater than the property’s fair market value, it did not
involve a bankruptcy. 3 See IRS Pub. 908 (Rev. Feb. 2020),
Bankruptcy Tax Guide, 2020 WL 1268263, at *30 (“None

3
Justice Blackmun took great care in Tufts to make clear that the
holding in the case did not involve issues raised by insolvency and the
cancellation of indebtedness. See id. at 310 n.11. Justice Blackmun’s
note of caution is, I believe, a sufficient response to the majority’s
criticism that I fail to explain why the reasoning of Tufts does not apply
in appellants’ case. Majority op. at 25 n.13.
34 MILKOVICH V. UNITED STATES

of the debt canceled in a bankruptcy case is included in the
debtor’s gross income in the year it was canceled. Instead,
certain losses, credits, and basis of property must be reduced
by the amount of excluded income (but not below zero).”)
(emphasis added). Milkovich and Nguyen, in other words,
cannot have it both ways―complete exoneration from
liability while claiming a tax benefit from an asset belonging
wholly to another (in this case, CitiMortgage). Nor, unlike
the case in Tufts, were Milkovich and Nguyen the sellers of
the debt as they had long ago pledged any sale proceeds to
CitiMortgage by deed of trust.

Finally, while I attribute no wrongdoing to Milkovich
and Nguyen in attempting to claim the interest
deduction―they saw their chance and took it―I believe
there is a moral hazard, as well as a threat to the integrity of
the Tax Code, in ratifying a legal fiction as a legitimate tax
deduction. For these reasons, I dissent.