The Tax Court held that a taxpayer couple's short sale did not result in a deductible loss because the sale of the house and the subsequent debt cancellation were both part of one transaction rather than two. The court also held that there was no gain or loss from the sale since the amount realized was greater than the taxpayers' loss basis but less than their gain basis.
Facts: In 2005, Karl and Christina Simonsen bought a townhouse in San José, Calif., for about $695,000, paying 20% down and financing the remainder with a loan from Wells Fargo. The couple lived in the townhouse until September 2010, when they moved to Southern California. The couple converted the townhouse to rental property and used what they believed to be the property's fair market value (FMV) of about $590,000 at the date of conversion (later stipulated to have been $495,000) to compute depreciation for 2011. In 2011, the Simonsens negotiated a sale with Wells Fargo and a third-party buyer for $363,000. Those proceeds were used to pay closing costs of $26,310 and to pay down the taxpayers' loan balance of $555,960. Wells Fargo canceled the remaining loan balance of $219,270 and transferred the townhouse's title to the buyer.
The taxpayers received Form 1099-S, Proceeds From Real Estate Transactions, from the title company showing proceeds of $363,000, and Form 1099-C, Cancellation of Debt, from Wells Fargo showing canceled debt of $219,270. On their 2011 federal income tax return, the couple reported a deductible loss of $216,495 (proceeds of $363,000 minus an adjusted basis of $579,495) and excluded the canceled debt of $219,270 from income as discharged qualified principal residence indebtedness. In 2014, the IRS sent the taxpayers a deficiency notice after it disallowed the loss. The Simonsens petitioned the Tax Court for relief.
Issues: In a short sale, the owner/debtor sells the property to a third party for an amount less than the outstanding loan balance. The seller agrees to transfer the entire proceeds to the lender, and the lender agrees to release its lien on the property. Whenever any liabilities of the seller are discharged as a result of the sale of property, the amount realized used to compute gain or loss includes the discharged debt. When indebtedness on a qualified principal residence (as defined by Sec. 121) is forgiven, Sec. 108(a)(1)(e) allows married taxpayers filing a joint return to exclude up to $2 million of the canceled debt from income.
The taxpayers argued that their sale was two tax transactions: (1) the sale of the property, resulting in a tax loss, and (2) the forgiveness of the remaining loan balance, excludable from income under Sec. 108(a)(1)(E). They argued that because they had used the townhouse as their principal residence for more than two of the five years preceding the short sale (as required for the Sec. 121 gain exclusion), it met the definition of a principal residence for purposes of Sec. 108(a)(1)(E) as well.
The IRS argued that the short sale was one transaction, and gain or loss should be calculated on that single transaction. The IRS further argued that if the court held that the short sale was two transactions, then the exclusion under Sec. 108(a)(1)(E) could not be used because the property was not their principal residence on the date of the short sale. Although Sec. 108(h)(5) provides that the term "principal residence" has the same meaning as when used in Sec. 121, the IRS took the position that the definition did not extend to the two-out-of-five-years rule of Sec. 121(a).
Holding: The Tax Court agreed with the IRS that the short sale was one transaction because Wells Fargo needed the taxpayers to transfer the sale proceeds to it to cancel the remaining debt so it could then reconvey the deed of trust and close the sale. To determine the gain or loss from the single transaction, the amount realized from the transaction must be compared to the townhouse's adjusted basis. The court held that the canceled debt of $219,270 must be included in the amount realized because Regs. Sec. 1.1001-2(a)(1) requires the inclusion of any debt of the seller that is discharged as a result of the sale. Since the debt was nonrecourse and the taxpayers had no obligation to Wells Fargo after the transaction, the debt was discharged, resulting in an amount realized of $555,960, according to the court.
The court held that no gain or loss should be recognized on the transaction because the amount realized of $555,960 was more than the property's FMV (stipulated to be $495,000) at the date of its conversion to rental property, adjusted for depreciation, but less than its adjusted basis of approximately $695,000, also adjusted for depreciation. This calculation is used for certain gift property (see Regs. Sec. 1.1015-1(a)(2)), and the court stated that, despite the lack of specific guidance prescribing its use here, this method was appropriate by analogy and logically coherent.
Since the court determined that there was only one transaction, i.e., a sale and no cancellation of debt, it held that Sec. 108(a)(1)(E) did not apply. Thus, the court did not decide whether the house needed to be the taxpayers' principal residence at the date of the sale for purposes of Sec. 108(a)(1)(E). It also held that no accuracy-related penalty should be applied since the taxpayers' reporting errors arose from an honest misunderstanding of "a complicated subject area that lacks clear guidance" and they had acted in good faith.
- Simonsen, 150 T.C. No. 8 (2018)
— By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.