George J. KENNEY, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee, and Ticor Title Co. of California, Defendant-counter-claimant. George J. Kenney, Plaintiff-Appellee, v. United States of America, Defendant-Appellant, and Ticor Title Co. of California, Defendant-counter-claimant. George J. Kenney, Plaintiff-Appellee, v. United States of America, Defendant-Appellant, and Ticor Title Co. of California; First Select Inc.; Eskanos & Adler, PC, Defendants. George J. Kenney, Plaintiff-Appellant, v. United States of America, Defendant-Appellee, and Ticor Title Co. of California; First Select Inc.; Eskanos & Adler, PC, Defendants., United States Court of Appeals, Ninth Circuit., 458 F.3d 1025, Nos. 04-16748, 04-17019, 05-15354, 05-15386., Filed Aug. 17, 2006

George J. KENNEY, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee, and Ticor Title Co. of California, Defendant-counter-claimant. George J. Kenney, Plaintiff-Appellee, v. United States of America, Defendant-Appellant, and Ticor Title Co. of California, Defendant-counter-claimant. George J. Kenney, Plaintiff-Appellee, v. United States of America, Defendant-Appellant, and Ticor Title Co. of California; First Select Inc.; Eskanos & Adler, PC, Defendants. George J. Kenney, Plaintiff-Appellant, v. United States of America, Defendant-Appellee, and Ticor Title Co. of California; First Select Inc.; Eskanos & Adler, PC, Defendants.

United States Court of Appeals, Ninth Circuit.

458 F.3d 1025

Nos. 04-16748, 04-17019, 05-15354, 05-15386.

Filed Aug. 17, 2006.

Argued and Submitted June 12, 2006.

Filed Aug. 17, 2006.

Benjamin C. Sanchez, Tierney, Watson & Healy, San Francisco, CA, for the appel╜lant.

Kenneth L. Greene and Marion M. Er╜ickson, U.S. Department of Justice, Wash╜ington, D.C., for the appellee/cross-appel╜lant.

Appeal from the United States District Court for the Northern District of Califor╜nia; Bernard Zimmerman, Magistrate Judge,* Presiding. D.C. No. CV-03-03848-BZ.

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* ═ Pursuant to a stipulation of the parties Magis╜trate Judge Bernard Zimmerman presided in this case.

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Before HUG and O'SCANNLAIN, Circuit Judges, and ROGER T. BENITEZ,** District Judge.

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** ═ The Honorable Roger T. Benitez, United States District Judge for the Southern District of California, sitting by designation.

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HUG, Circuit Judge.

This case concerns U.S. Government ("Government") tax liens on the proceeds of the sale of a house owned by George Kenney ("Kenney") and his former wife, Donna. They owned the house as joint tenants. The Government liens extend only to Donna's interest in the proceeds. Over the years Kenney had made the en╜tire payments on the notes secured by deeds of trust on the property, both his share and Donna's share. He contends that pursuant to oral agreements with Donna those payments of her share were to be applied to diminish Donna's interest in the house, and by the time the Govern╜ment liens attached Donna had no remain╜ing interest in the house or the proceeds of the sale of the house. Kenney and the Government also disagree on how Kenney should receive equitable subrogation for the loan payments he made; at issue is the amount of the proceeds to which the Gov╜ernment is entitled and whether Kenney should receive interest on his equitable subrogation. There is also an issue of entitlement to litigation costs and attorneys fees. We have jurisdiction under 28 U.S.C.╖ 1291.

I. Factual Background

In December 1 978, Kenney and Donna purchased a house in Fremont, California. Kenney and Donna paid $25,000 down and obtained a loan for the remaining $52,950 of the house's cost. Kenney and Donna were co-obligors on a promissory note se╜cured by a deed of trust on the house, and they held title as joint tenants.

In June 1989, Kenney and Donna per╜manently separated. In August 1991, Kenney agreed to assist Donna in obtain╜ing an additional $59,750 loan from a dif╜ferent lender. The loan proceeds were paid to Donna alone, but Kenney and Don╜na jointly executed a note and second deed of trust against the house to secure the promissory note. Pursuant to oral agree╜ments between Kenney and Donna made between 1989 and 1991, Kenney agreed to assume responsibility for the two loans on the house. From 1989 until the house was sold in 2002, Kenney made all of the pay╜ments on the loans. In total, Kenney paid principal and interest of $166,826 on the two loans, according to the parties' joint stipulation for summary judgment.

Between November 1995 and April 1997, the Government filed five tax liens against Donna relating to her business for tax years 1991-1995. In 1996, Kenney and Donna began divorce proceedings. On November 29, 1996, they entered into a property settlement agreement. The agreement was incorporated into the judg╜ment of marriage dissolution, filed on March 6, 1997. Under the agreement, Donna was required to execute a quitclaim deed to the residence in favor of Kenney. She executed this deed on October 9, 1999.

Kenney subsequently decided to sell the house. To allow this in light of the Gov╜ernment's liens against Donna's share, the Government and Kenney entered into a substitution-of-proceeds agreement. Un╜der this agreement, Kenney agreed that the liens would attach to the sale proceeds to the same extent as to the house itself.

On July 2, 2002, the house was sold for $395,000. The net proceeds were $307,244, after payment of the balances due on the notes secured by the deeds of trust and expenses of sale. The Govern╜ment asserted its liens against one-half of those proceeds, or $153,622, which was held in escrow by Ticor Title Company of California.

II. Procedural History

On August 19, 2003, Kenney filed a com╜plaint against the Government to quiet title in the sale proceeds under 28 U.S.C. ╖ 2410. He named Ticor as a co-defen╜dant, but Ticor was dismissed from the suit after the sale proceeds and interest earned on the proceeds were taken from escrow and deposited with the clerk of the court.

On June 30, 2004, Kenney and the Gov╜ernment filed cross motions for summary judgment. Kenney contended in his mo╜tion for summary judgment that, as a re╜sult of his payments on the notes secured by the deeds of trust and the oral agree╜ments with Donna, Donna's interest in the house and proceeds had diminished to zero. As an alternate theory, Kenney con╜tended that he was entitled to equitable subrogation against Donna's interest for the payments he had made on Donna's share of the notes secured by the deeds of trust. Kenney also contended that he was entitled to interest on the payments he made on behalf of Donna.

In reply, the Government denied Ken╜ney's entitlement to recovery under his "diminishing interest" theory, but agreed that he was entitled to equitable subroga╜tion, although this theory had neither been mentioned in the complaint nor had facts consistent with this theory been alleged in the complaint. The Government denied that he was entitled to interest on the payments he paid for Donna's share. The Government also arrived at a different cal╜culation of the manner in which the equita╜ble subrogation was to be applied and sought summary judgment for a different amount.

In a published order on July 30, 2004, the district court granted summary judgment in part to the Government and de╜nied summary judgment to Kenney. Ken╜ney v. United States, 329 F.Supp.2d 1193 (N.D.Cal.2004). The order rejected Ken╜ney's diminishing interest theory, but cal╜culated an equitable subrogation award for Kenney that did not include interest on his payments as Kenney requested. Id. at 1198. The court rejected the Govern╜ment's calculation of the equitable subro╜gation and adopted in substance Kenney's calculation. Final judgment was entered August 11, 2004.

On August 24, 2004, Kenney filed a mo╜tion for an award of litigation costs under 26 U.S.C. ╖ 7430, which the district court granted to the extent that the costs were attributable to the equitable subrogation theory. The district court made this order an amendment nunc pro tunc to the final judgment. The district court also ordered the parties to present specific evidence of litigation costs, and on February 22, 2005 the district court granted Kenney $5,814.38 in litigation costs ($5,664.38 in attorney fees and $150 in costs).

The Government and Kenney filed time╜ly notices of appeal from both the August 2004 final judgment and February 2005 order.

III. Analysis

1. Kenney's Diminishing Interest Theory

We review de novo a district court's partial grant of summary judgment in fa╜vor of the United States. United States v. $100,348 in U.S. Currency, 354 F.3d 1110, 1116 (9th Cir.2004).

Kenney's opening brief argues that as a result of the oral agreements to assume Donna's loan obligations, Donna impliedly agreed to proportionately transfer to Kenney her equity interest in the house. Therefore, Kenney would have gained all of Donna's interest before the tax liens attached. However, in his reply/answering brief, Kenney concedes that this argument has been foreclosed by In re Marriage of Benson, 36 Cal.4th 1096, 32 Cal.Rptr.3d 471, 116 P.3d 1152 (2005), which held that such agreements are required to be in writing. Kenney then raises the new ar╜gument that the precedent established by Benson suggests that remand is necessary to "address the question of what additional rights against the property, if any, Kenney may have that are superior to the tax liens." But Benson established no new rights, and Kenney already had a full op╜portunity to present legal and equitable theories to the district court.

2. Calculating Kenney's equitable subrogation award

The parties do not dispute that Kenney is entitled to equitable subrogation for some of the house sale proceeds. To whatever extent Kenney is subrogated to the rights of the lenders, he has priority over the Government in the disputed pro╜ceeds, since the lenders' interests are sen╜ior to the later-filed Government liens. ¹ The method of calculating Kenney's equi╜table subrogation award is a question of law. We review de novo the district court's conclusions of law. Tritchler v. County of Lake, 358 F.3d 1150, 1154 (9th Cir.2004).

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^1. ═ Under 26 U.S.C. ╖ 6323(i)(2), state law sub╜rogation rights are recognized in determining tax lien priority rights. See Fidelity Nat'l Title Ins. Co. v. United States, 907 F.2d 868, 870 (9th Cir.1990). California law recognizes eq╜uitable subrogation. See, e.g., Caito v. United California Bank, 20 Cal.3d 694, 144 Cal.Rptr. 751, 576 P.2d 466, 471 (1978).

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Under the district court's method, the $307,244 net proceeds were divided into equal shares of $153,622 for Kenney and Donna, whereupon equitable subroga╜tion was applied to credit Kenney $83,413 from Donna's $153,622 share. The $83,413 represents half of the $166,826 in mort╜gage payments that Kenney made between 1989 and 2002 on the two notes. ² After deducting the $83,413 award from Donna's share of $153,622, there remained $70,209 in Donna's share available to satisfy the Government liens.

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^2. ═ We use the subrogation calculation from the district court's final judgment, not the sum╜mary judgment order. In an earlier calcula╜tion for the summary judgment order, the district court used the figure of $167,269 as the amount of the payments on the notes rather than the $166,826 to which both par╜ties now agree.

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On appeal, the Government argues that Kenney's $83,413 should be taken from the total net proceeds of $307,244, leaving a balance of $223,831 to divide between Kenney and Donna, of which $111,915.50 (Donna's half) would be avail╜able to satisfy the Government liens. The Government's approach would increase its portion by $41,706.50. The Government argues that because equitable subrogation only allows Kenney to "stand in the shoes" of the lenders, he should be paid from the net proceeds as a lender, before his and Donna's shares are divided. ³

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^3. ═ By undertaking to pay a debtor's obligation to a creditor, the subrogee is equitably subro╜gated to the position of the creditor and suc╜ceeds to the creditor's rights against the debtor; "[t]he right of subrogation is purely derivative." Reliance Nat'l Indem. Co. v. General Star Indem. Co., 72 Cal.App.4th 1063, 85 Cal.Rptr.2d 627, 635 (1999).

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As the district court noted, the Govern╜ment's method would force Kenney to take his subrogation award from proceeds in which he has a half interest, effectively forcing him to pay for half of the amount to which he is entitled. See Kenney, 329 F.Supp.2d at 1198. The Government re╜lies on Caito v. United California Bank, 20 Cal.3d 694, 144 Cal.Rptr. 751, 576 P.2d 466 (1978) in contending that only the $83,413 paid on Donna's account should be deducted as equitable subrogation from the entire proceeds of the sale before the division between Donna and Kenney. The Caito case does not support the Govern╜ment's position. In that case the Caitos and the Caponis were cotenants of a farm and secured a loan from Bank of America ("B of A") secured by a deed of trust on which the parties were equally liable. The Caponis executed another note to United California Bank ("UCB") that was secured by a deed of trust on the Caponis' one-half interest in the farm. The Caitos operated the farm and made payments of $17,500 to B of A from the proceeds of the farm operation. Ultimately B of A fore╜closed and at issue was the amount of proceeds from the sale of the farm in excess of B of A's lien that UCB, as the Caponis' lien holder, was to receive. The California Supreme Court held that in ap╜plying equitable subrogation the Caitos would be entitled to the amount they paid for the Caponis' share of the obligation. The court stated, "UCB could not expect to benefit from an improved security posi╜tion resulting from the Caponis' debt paid by the Caitos. The Caitos would then have paid a debt ▒for which another is primarily liable, and which in equity and good conscience should have been dis╜charged by the latter.' " Caito, 144 Cal. Rptr. 751, 576 P.2d at 472 (citations omit╜ted). ⁴ The method of calculation proposed by the Government would allow the Gov╜ernment to benefit from an improved se╜curity position resulting from Donna's debt paid by Kenney.

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^4. ═ Ultimately the supreme court held that the $17,500 proceeds of the farm belonged to both the Caitos and the Caponis and was not an amount paid solely by the Caitos, and thus, the Caitos were not entitled to equitable sub╜rogation. Caito, 144 Cal.Rptr. 751, 576 P.2d at 473. The court also did not credit the Caitos under equitable subrogation an amount of $6,000 that had been loaned di╜rectly to the Caponis. Id .

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Several other California cases establish that Kenney should be credited from the total net proceeds for the $166,826 in prin╜cipal and interest payments that he made. Southern Adjustment Bureau, Inc. v. Nel╜son , 230 Cal.App.2d 539, 41 Cal.Rptr. 148, 149 (1964), held that

[w]hen a cotenant makes advances from his own pocket to preserve the common estate, his investment in the property increases by the entire amount ad╜vanced. Upon sale of the estate he is entitled to be reimbursed his entire ad╜vancement before the balance is equally divided.

(emphasis added). ⁵ In Vides v. Vides, 215 Cal.App.2d 601, 30 Cal.Rptr. 447 (1963), a wife paid the mortgage installments on a house after her husband refused to pay. Upon the sale of the house, the court held that "the wife's use of her separate funds to discharge this obligation of the commu╜nity gives her a right at least akin to subrogation." Id. at 448. The court held that the wife should first be reimbursed from the net proceeds for the installment sums she had paid, with the remaining proceeds then divided equally between the spouses. Id .

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^5. ═ See also Milian v. De Leon, 181 Cal.App.3d 1185, 226 Cal.Rptr. 831, 836 (1986) (A coten╜ant who pays trust deed payments against the property "is entitled to contribution from the cotenant, and on partition by sale is entitled to reimbursement for those expenditures be╜fore division of the proceeds among the prop╜erty owners.").

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It is apparent that there are two methods of calculation that arrive at the same result. Under one method of calcu╜lation, Kenney's payments of $166,826 are deducted from the net proceeds of $307,244 for a balance of $140,418. Don╜na's half of those proceeds would be $70,209, to which the Government is enti╜tled. The other method is the one used by the district court in the instant case. The total net proceeds of $307,244 are divided, leaving Donna with her share of $153,622. From that is deducted one-half the pay╜ments made by Kenney ($83,413). This deduction leaves an identical final balance of $70,209 to which the Government is entitled. It is obvious that the full $166,826 Kenney paid should not be de╜ducted from Donna's share because one-half of that amount is applicable to his share. It is equally obvious that it is inequitable to deduct only half of the pay╜ments, $83,413, from the total net proceeds before dividing them, as the Government contends, because this would leave Kenney recovering only one-half of the payments he made for Donna. Equitable subroga╜tion "is not a fixed and inflexible rule" and its development is "the natural conse╜quence of a call for the application of justice and equity to particular situations." In re Johnson's Estate, 240 Cal.App.2d 742, 50 Cal.Rptr. 147, 149 (1966) (internal quotation omitted).

The district court reached the correct result in its calculation, holding that Ken╜ney is entitled to $83,413 out of the $153,622 held in escrow; however, we must adjust its final conclusion, because the court incorrectly gave the Government all of the $2,735 escrow interest on the $153,622. Kenney's award of $83,413 is 54% of the $153,622 in controversy, so he should properly receive 54% ($1,477) of the $2,735 escrow interest on the $153,622. His net award, therefore, should be $84,890 of the $156,357 in proceeds depos╜ited with the clerk of the court. The Government should receive $1,258 in es╜crow interest in addition to its $70,209, leaving it with $71,467 of the $156,357. Any additional interest earned after the disputed proceeds were deposited with the clerk should be distributed 54% to Kenney and 46% to the Government.

3. Denial of interest on Kenney's equitable subrogation award

The district court enjoys broad powers in equity, and "its choice of equita╜ble remedies is reviewed for an abuse of discretion." Labor/Cmty. Strategy Ctr. v. Los Angeles County Metro. Transit Auth., 263 F.3d 1041, 1048 (9th Cir.2001). "The district court abuses its discretion when its equitable decision is based on an error of law or a clearly erroneous factual finding." United States v. State of Washington, 157 F.3d 630, 642 (9th Cir.1998).

Kenney argues that the district court erred in denying him interest on the pay╜ments he made for Donna. The district court stated that it denied interest because Kenney "has received a return on his in╜vestment through the appreciation in the value of the Property." Kenney, 329 F.Supp.2d at 1198. Kenney cites Caito v. United California Bank, 20 Cal.3d 694, 144 Cal.Rptr. 751, 576 P.2d 466 (1978), to argue that the district court erred in deny╜ing interest by taking into account Ken╜ney's gain from the substantial apprecia╜tion in his interest in the house. This case is not applicable. Caito did not concern whether interest should be considered in an equitable subrogation award.

Under its broad powers in equity, the district court did not abuse its discre╜tion in denying interest. The district court was free to consider that Kenney's payments on behalf of Donna enabled him to protect his own half interest in the property-and that the property appreci╜ated during the relevant time period. It appreciated in value from $246,000 in 1989 when Donna and Kenney separated to $395,000 when it was sold in 2002. We therefore affirm the district court's denial of interest on Kenney's equitable subroga╜tion award.

4. The award of litigation costs to Kenney

Section 7430(a) of Title 26 of the United States Code provides that a "pre╜vailing party" in federal tax administrative or court proceedings may be awarded rea╜sonable administrative and litigation costs. Kenney received an award of his litigation costs under section 7430(a), but did not request or receive an award for his admin╜istrative costs. The parties agree that Kenney was the prevailing party under section 7430(c)(4)(A), but dispute whether the Government established that its litiga╜tion position was "substantially justified" under section 7430(c)(4)(B). If the Gov╜ernment's position was substantially justi╜fied, Kenney is not treated as the prevail╜ing party. Id. "Substantially justified" means "justified to a degree that could satisfy a reasonable person," or having "reasonable basis both in law and fact." Pierce v. Underwood, 487 U.S. 552, 565, 108 S.Ct. 2541, 101 L.Ed.2d 490 (1988). To be substantially justified means more than "merely undeserving of sanctions for frivolousness." Id. at 566, 108 S.Ct. 2541.

The district court's determination of whether the position of the United States was substantially justified is reviewed for abuse of discretion. Pierce, 487 U.S. at 559, 108 S.Ct. 2541; Huffman v. C.I.R., 978 F.2d 1139, 1143 (9th Cir.1992). The district court abuses its discretion if it bases its decision on an erroneous legal conclusion or a clearly erroneous finding of fact. United States v. Marolf, 277 F.3d 1156, 1160 (9th Cir.2001).

We have held that the reasonable╜ness of the Government's position is ana╜lyzed separately for the administrative and the judicial proceedings. "[T]he posi╜tion taken in the administrative proceed╜ing does not automatically apply to the judicial proceeding . . . [A] bifurcated analysis of ▒substantially justified' should be made in each proceeding." Huffman, 978 F.2d at 1146. The district court abused its discretion in analyzing the Gov╜ernment's position in the litigation pro╜ceedings by including its position in the administrative proceedings. Kenney made no claim for costs and fees from the administrative proceeding. Huffman re╜quires a bifurcated analysis of the Govern╜ment's position in the administrative pro╜ceedings separate from its position in the court proceedings.

In analyzing the legislative intent behind section 7430, Huffman noted that if the Government's position in an adminis╜trative proceeding is not applicable, the Government's position is that taken in the litigation. Id . at 1146. Because Kenney requested only litigation costs, we only examine the Government's litigation posi╜tion. The district court referenced a 2002 Kenney letter to IRS administrators in the administrative proceeding that asserted a right of subrogation, and the court wrong╜ly faulted the Government for not respond╜ing to the assertion until the summary judgment stage of litigation. This mixes the analysis of administrative and judicial proceedings in a manner that contradicts Huffman.

Under the proper analysis, it is difficult to find the Government's litigation position unreasonable. It is important that Ken╜ney did not allege facts consistent with an equitable subrogation argument in his complaint filed in the district court. In fact, the key allegation that Kenney ad╜vanced in his complaint under the heading "Plaintiff's Acquisition of Interest"-that Donna's interest in the home was zero when the Government's November 1995 and June 1996 notices of tax liens were filed-is inconsistent with equitable subro╜gation but fully consistent with Kenney's diminishing interest claim.

In its answer to Kenney's complaint, the Government denied Kenney's diminishing interest allegation. "Generally, the position of the United States in the judicial pro╜ceeding is established initially by the Gov╜ernment's answer to the [complaint]." Huffman, 978 F.2d at 1148. The Govern╜ment's answer to Kenney's complaint was entirely defensible. Indeed, the district court granted summary judgment to the Government on the diminishing interest theory, a grant that we affirm in this opinion. For purposes of avoiding section 7430 costs, it cannot be the Government's duty to address factual allegations not raised in a complaint. Had Kenney made factual allegations that would have put the Government on notice of an equitable sub╜rogation theory, and had the Government denied them, the Government's litigation position as taken here might not have been substantially justified. See Hanson v. C.I.R., 975 F.2d 1150, 1156 (5th Cir.1993) (rejecting an approach wherein the Gov╜ernment could "pursue a substantively un╜reasonable theory in litigation, settle the case on the eve of summary judgment, and escape an award of litigation costs to the prevailing tax litigant").

Only in his motion for summary judgment, ten months after he filed his complaint, did Kenney assert equitable subrogation before the district court. In response to the motion, the Government conceded that equitable subrogation ap╜plied but disputed the amount that was available to Kenney. The Government's response was reasonable under these cir╜cumstances. See Huffman, 978 F.2d at 1148 ("Case law holds that if the Govern╜ment concedes the petitioner's case in its answer, its conduct is reasonable.").

We therefore reverse the district court's order granting Kenney's motion for litiga╜tion costs, and the district court's award to Kenney of $5,814.38 in litigation costs. The district court abused its discretion in finding the Government's litigation posi╜tion not substantially justified.

IV. Conclusion

For the reasons expressed above, we AFFIRM the district court's summary judgment grant in favor of the Govern╜ment on Kenney's diminishing interest the╜ory. We AFFIRM the district court's cal╜culation of Kenney's equitable subrogation, but adjust the amount to reflect the appro╜priate amount of interest on the funds held in escrow. We AFFIRM the district court's denial of interest on Kenney's equi╜table subrogation award. We REVERSE the district court's award of litigation costs to Kenney.

AFFIRMED IN PART. REVERSED IN PART.

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