Private lenders

[Judge Roy Bean]

Something that keeps cropping up in the mortgage disaster are some "private" lenders who have jumped in and made loans to people in trouble. Sounds nice, but then we come to this situation - a loan secured by a promissory note on a second property to save the first property from foreclosure.

The "lender" is a friend of the borrower's family. They execute a promissory note and sure enough - it's one of those pulled of the Internet that is not all that well defined in terms of what might happen if something goes off the rails. The unsophisticated lender party doesn't even bother to record it.

Years go by on this ten-year note and the families don't exactly keep track of things. In fact, during one year, no payments are made at all, then the borrower comes into some other money and writes the lender a check for over half the note - which if you put it all out on a spreadsheet represents a major prepayment of principal.

None of this is causing friction between them - it's a kind of "pay us when you can" relationship and it worked.

Fast forward a couple of years and the lenders are now deceased. The borrower starts digging through her records and somehow comes to the conclusion that she paid way too much.

On the other side, having found the note, the executor of the lender's estate comes to just the opposite conclusion - that no payments were made on the note.

Enter ADR, round 1. Expert's affidavit shows that indeed, the borrower had paid far too much, mostly because of the one giant payment. The big check was deposited - what they did with it is a mystery.

Now, IMHO there are tax implications - turns out none of the interest paid on this loan (close to six figures) could have been reported as income by the now-deceased lenders. Given the lack of sophistication in record keeping by the lenders, there is no way they could have reported anything other than a guess.

Question 1 - How exposed is the estate of the lending couple for being lousy record keepers - and would the IRS take the borrower's records from the civil action into consideration? Keep in mind the only records that exist are the borrower's canceled checks, most with no annotation. For all the IRS knows, one of the big checks might have been to buy some kind of non-real property - but that kind of transaction didn't actually happen, at least according to the borrower.

Question 2 - Does counsel for the lender's executor (who was aggressively pursuing the collection of the alleged amount owed) have an obligation to go back and correct the failure to report the interest income over the last seven years?

Any opinions would be welcome.

[Cathulhu]

I don't know enough about estate taxes to offer an opinion, but for what it's worth, on Question 2 I think that technically there would be a requirement to amend the returns and show imputed interest, and I'd hate like poison to figure it all up.

[Imalawman]

I had a similar situation occur not terribly long ago. It wasn't a loan, but it was some other lack of record keeping = unreported taxes issue. The IRS, upon the taxpayer's death went back and figured out that he had under-reported his income for the last 3 years. We did some checking and it looked like he probably under-reported for the last ten years. However, we determined that it did not rise to the level of fraud, just sloppiness and unsophistication. Moreover, we felt that since the taxpayer was now deceased, there was no reason to amend tax returns, because there was no liability to the beneficiaries (my client) for the taxes once the estate was finalized. Let the IRS do their work, we don't represent the taxpayer. The IRS got their pound of flesh for the last three years out of the estate and everyone moved on.

I suppose there is an ethical question if I were representing the estate and the deceased taxpayer. But still, I really don't think you have to go back and amend the returns. Perhaps list the IRS as a potential creditor, giving them notice. They then can figure out the tax on their own. You've notified them of a potential problem and done your part. Interesting question, but I think I'd just notify the IRS and let them worry about.

I think you also should consider the SOL, if you do decide to go back and amend as you may only have 3 years of liability - you shouldn't have 7 at least.