Issuance of 1099-C Does Not Void Equitable Lien on Foreclosure Surplus

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The United States District Court for the District of Massachusetts, in a matter of first impression in the First Circuit, has joined the majority of courts to find that a junior lienholder's issuance of a 1099-C to a mortgagor following foreclosure does not extinguish the junior lienholder's claim to excess proceeds from a senior lienholder's foreclosure. Wells Fargo Bank, N.A and Orlans PC, Plaintiffs, v. Thomas Fraze et al., Defendants.

Fraze purchased the property in 2008 and, in 2009, granted a mortgage that was eventually assigned to Wells Fargo Bank, N.A. ("Wells Fargo"). In January 2017, Wells Fargo foreclosed on the property and, along with its attorneys, filed an interpleader action to determine who was entitled to the $15,456.93 surplus remaining. The United States Department of Housing and Urban Development ("HUD") held a junior mortgage, which under Massachusetts law gave it an equitable lien on those surplus proceeds, and asserted a claim to the entire surplus.

Following the foreclosure, HUD sent Fraze an IRS Form 1099-C entitled "Cancellation of Debt" indicating that HUD had discharged Fraze's $59,965.62 debt to HUD, which was secured by HUD's junior mortgage. Fraze asserted that HUD's issuance of the 1099-C effectively operated to discharge the debt owed to HUD, and that Fraze was therefore entitled to the surplus.

Joining the majority of courts to have considered this issue, the Judge O'Toole of the District of Massachusetts disagreed with Fraze. The issuance of a 1099-C is required by IRS regulations under certain circumstances "whether or not an actual discharge of indebtedness has occurred...". In this case, the circumstance was HUD's decision and policy to discontinue collection activity. Absent any evidence that HUD actually cancelled or discharged Fraze's debt, the issuance of the 1099-C was simply the fulfillment of an IRS reporting requirement, and did not legally discharge or otherwise cancel the underlying debt.

Accordingly, as the junior lienholder of record, HUD's equitable lien on the surplus proceeds, a superior interest to Fraze's, and was entitled to the surplus funds.

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