Short Sale of Rental Property and Discharge of Mortgage Debt Resulted in No Gain or Loss

(Parker Tax Publishing April 2018)

The Tax Court held that a short sale of real property that was converted to a rental property and that was purchased using nonrecourse debt was a single transaction in which the amount of the discharged debt had to be included in the amount realized for the purpose of determining gain or loss on the sale. The court noted that the amount realized was greater than the couple's loss basis in the property under Reg. Sec. 1.165-9(b)(2), but less than the couple's gain basis in the property and, because the property was sold for an amount between those bases, the court found there was neither a gain nor a loss on the sale. Simonsen v. Comm'r, 150 T.C. No. 8 (2018).

Facts

Karl and Christina Simonsen bought a townhouse in San Hose, California in 2005 for $695,000. They financed the purchase with a nonrecourse loan from Wells Fargo. The lived in the home until 2010, when they decided to convert the townhouse to a rental property and move to southern California. Due to the recession, the value of the townhouse had decreased, and its fair market value at the time of the conversion was only $495,000. By late 2011, the market had not rebounded and the Simonsens negotiated a sale with Wells Fargo and a third party buyer that yielded only $363,000. All the proceeds went to Wells Fargo to pay down the loan and cover closing costs. Wells Fargo forgave the remaining loan balance.

In January 2012, the Simonsens received two Forms 1099. Wells Fargo sent a Form 1099-C, Cancellation of Debt, showing that the bank had cancelled the Simonsens' remaining $219,000 debt. The Simonsens also received a Form 1099-S, Proceeds from Real Estate Transactions, from the title company reporting sale proceeds of $363,000.

Following the apparent form of the transaction, the Simonsens reported on their 2011 tax return a sale for $363,000 and cancellation of indebtedness (COI) income of around $219,000. They thought the sale resulted in a loss of $216,495, calculated as the difference between the sale price and their converted adjusted basis (reduced by depreciation) of $579,495. They excluded the COI amount based on Code Sec. 108(a)(1)(E).

Observation: The discharge of up to $ 2 million of indebtedness income for married taxpayers filing jointly related to a discharge of qualified principal residence debt was generally excludable from gross income under Code Sec. 108(a)(1)(E) for qualified principal residence debt discharged from 2008 through 2017.

Mrs. Simonsen, who completed the return, determined that although the couple was not currently living in the townhouse, it was their principal residence at the time of the sale because they had lived there for at least two of the last five years as required under Code Sec. 121. Mrs. Simonsen is a lawyer but has no tax background. She reviewed the IRS's instructions before concluding that none of the COI income was taxable and that no basis adjustment was required before determining gain or loss because they no longer owned the property. She used TurboTax to prepare the return like she had every year since 2002.

The IRS audited the Simonsens and sent a notice of deficiency in 2014, indicating a deficiency of just under $70,000 and an accuracy related penalty of $14,000. The Simonsens petitioned the Tax Court, arguing that Code Sec. 108(a)(1)(E) changed the treatment of short sales by requiring the tax consequences of the sale to the determined first, before calculating the cancellation of debt. The IRS argued that the short sale was a single transaction and that the COI amount should have been added to the Simonsens' amount realized to calculate the gain or loss. Any gain realized would be taxable gains derived from dealings in property, and not excludable COI income, according to the IRS. Even if there were two transactions, the IRS argued that the Simonsens would not be entitled to exclude the COI income because the townhouse was not their principal residence at the time of the sale.

Analysis

The Tax Court agreed with the IRS that the short sale was one transaction and that the Simonsens should have included the COI income in their amount realized to determine their gain or loss. The court observed that there were cases holding that a nonrecourse loan satisfied at less than the full amount owed produced COI income, but found that such cases were exceptional, and the more common outcome was that a disposition of encumbered property is a sale or exchange in which the nonrecourse debt is included in the amount realized. The court agreed with the Simonsens that the townhouse was their principal residence when they sold it because during the five years before they sale they had lived in it as their principal residence for three years and ten months. However, that finding was not determinative because the court found that the sale was only one transaction and no COI income arose.

The sale was a single transaction, in the court's view, primarily because Wells Fargo's willingness to cancel the debt depended entirely on the Simonsens' willingness to turn over the proceeds from the sale of their home. The court found that the IRS's position was consistent with the obvious realities of the transactionthat Wells Fargo had to reconvey the deed of trust in order for the sale to close, and that it could dictate the terms of the sale as long as it retained the deed of trust. Other factors that suggested a single transaction were that Wells Fargo facilitated the short sale and received the sale proceeds, that Wells Fargo accepted the sale the amount even though it was insufficient to completely pay off the mortgage, and that the debt forgiveness occurred when the sale closed.

However, the Tax Court had a problem in determining the amount of gain or loss on the sale because the amount realized was $555,960, which fell between the basis the court would use to calculate a loss ($495,000) and the basis the court would use to calculate a gain ($695,000). The court noted that, where such a transaction involves a short sale, there was no guidance and the closest analogy it could find was to look at what happens to bases in property that one person gives another. The court looked to Code Sec. 1015(a) and Reg. Sec. 1.1015-1(a)(1) which provides that when one person gifts property to another, the donee uses the lower fair market value to compute a loss but the donor's basis to compute a gain. And, as far as what to do when a donee sells the gift at a price between those two possible bases, the court found the answer in Reg. Sec. 1.1015-1(a)(2): there is no gain or loss. Thus, the court held that the couple realized no gain or loss on the sale of their property

With respect to the accuracy related penalty, the Tax Court found that the IRS produced no evidence that it complied with the written approval requirement under Code Sec. 6751(b)(1) in assessing the penalty. However, even if the IRS had met its burden of production, the court found that the Simonsens acted with reasonable cause and good faith because they were not tax professionals and their reporting of the transaction was consistent with the information returns they received. The court noted that Mrs. Simonsen had used TurboTax for almost a decade, and although the receipt of COI income was new to her, she consulted the IRS's instructions before filing the return. The court also noted that there were no regulations under Code Sec. 108(a)(1)(E) and that caselaw was scarce. The court concluded that the Simonsens' error was the result of an honest misunderstanding of a complex area of the law, so they had therefore acted in good faith.

For a discussion of the tax treatment of short sales of real estate, see Parker Tax ¶72,375. For a discussion of the rules relating to the calculation of gain or loss on the sale of a residence converted to rental property, see Parker Tax ¶86,150.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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