Court finds settlement proceeds from mortgage fraud lawsuit were not includible in income

In a Summary Opinion, the Tax Court found that a taxpayer did not have $10,000 in unreported income with regard to settlement proceeds resulting from a mortgage fraud lawsuit. Kadir v. Commissioner, T.C. Summ. Op. 2014-43.

In Kadir, the taxpayer had refinanced his mortgage to try to lower his monthly payments, and ended up with two mortgages. He eventually stopped paying these mortgages and sued the two servicing companies and the originator for fraud and for violation of the Federal Truth In Lending Act. The parties to the lawsuit settled the case, and the settlement agreement required the originator to pay the taxpayer $10,000. However, the settlement agreement also required that the taxpayer pay all of the funds he received to the two servicing companies.

Although the taxpayer received a Form 1099-MISC reporting the $10,000 as nonemployee compensation, the taxpayer didn't include the $10,000 that he received from the settlement as income on his tax return. The IRS audited the tax return and increased the taxpayer's income by the $10,000 reported on the 1099-MISC. The taxpayer argued that he shouldn't be required to include the settlement proceeds in income because he was required to turn around and pay those same proceeds to the servicing companies. The taxpayer likened this situation to a mailman picking up an envelope with a $10,000 check and delivering it to its final address.

The Tax Court agreed, citing cases where there was an initial payment to a party who had a "binding commitment" to use that money to pay another party. The settlement in this case was intended to get some money from the originator to the servicers, even if the money first went through the taxpayer's bank account, and therefore the proceeds were not taxable.

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