PA Upholds Taxing Principal and Interest Discharged in Foreclosure

Mortgage lenders have a new friend, Pennsylvania’s Department of Revenue.

In last month’s Marshall v. Commonwealth, --- A.3d ---, 2012 WL 8704 (Pa. Cmwlth. 2012) opinion, the Commonwealth Court ruled that principal and unpaid interest discharged in a property’s foreclosure is subject to Pennsylvania’s personal income tax (“PIT”).

Pennsylvania’s PIT taxes each dollar of income at 3.07% for both residents (applying to all income received in a taxable year) and nonresidents (applying only to income from sources within the Commonwealth).

The Marshall dispute stemmed from the Department requiring a nonresident and limited partnership investor to pay PIT on his share of $2.6 billion of accrued and unpaid interest that was discharged in the foreclosure of the partnership’s apartment building.

The partnership had financed $308 million of the building’s purchase price with a “nonrecourse purchase money mortgage note”, the only remedy for nonpayment of which was foreclosure.

After determining that his distributive share of the $2.6 billion of unpaid interest was $3.9 million and that the partnership used $121.6 million to offset income that would have been subject to PIT, the Department assessed plaintiff $165,000.

In upholding the assessment, the Commonwealth Court cited the CIR v. Tufts, 461 U.S. 300 (1983) holding that when a lender forecloses on property securing a nonrecourse loan, the full amount of the nonrecourse obligation is subject to federal income tax.

Beyond spanking an out-of-state tax scofflaw, the Marshall v. Commonwealth ruling imposes consequences on commercial real estate investors skipping out on loans.

Because unpaid accrued interest is now deemed a gain following the taxable event of a foreclosure, an incentive exists for commercial borrowers not to default upon mortgage loans.

Further, because the Marshall v. Commonwealth ruling reaches through a partnership and across to state lines to assess a Texas investor’s gain, shifty investments hiding behind the shell of a fishy partnership will now enjoy less protection.