TAXLITIGATOR – Tax Controversy (Civil & Criminal) Report

In the years following the Mortgage Crisis many taxpayers did short-sales of their homes.  Many of them tried renting their homes before doing a short sale or allowing the home to go into foreclosure. Guidance on the tax consequences of short sales have been non-existence.  It only recently, in Simonsen v Commissioner, 150 T.C. No. 8 (March 15, 2018), that the Tax Court addressed the tax consequences of a short sale that occurred after the taxpayers converted their home to a rental property.

The Simonsens purchased a condominium in 2005 in San Jose for $695,000.  They put 20% down and borrowed the remainder of the purchase price from Wells Fargo Bank.  The condominium was their principal residence until late 2010, when they moved to southern California. They converted the condominium to a rental unit.  In late 2011, they negotiated a short sale of the property for $363,000.  After $26,000 in costs, the balance went to Wells Fargo Bank which applied it to pay down the loan.  It wrote off the unpaid balance of the loan and issued a Form 1099-C to the Simonsens for $219,270 of cancellation of debt income.

The Simonsens used Turbo-Tax to prepare their return.  They treated the short sale as two separate transactions: a sale of the condominium and a cancellation of debt.  Since the price, $363,000, was less than the cost basis less depreciation, they reported a loss on the sale of $216,000.  Under the 2007 Mortgage Forgiveness Debt Relief Act, a taxpayer does not recognize cancellation of debt income from “qualified principal residence indebtedness.”  Consequently, they did not report cancellation of debt income.

Not so fast said the IRS.  The IRS took the position that since the Simonsens had converted their residence to a rental, the condominium was not their “principal residence” for purposes of the exclusion.  Further, the short sale was really a sale for the amount of the note, which was $555,960.  Finally, the IRS determined that when they converted the property to a rental unit, the Simonsens’ basis became the fair market value on the date of the conversion.  Since this was $495,000, instead of a loss and no COD income the Simonsens had taxable gain of $60,000.  The IRS also asserted an accuracy penalty.

The first issue was whether the condominium was the Simonsens’ principal residence.  Pointing to sec. 121, the Simonsens argued that since they resided there at least two of the preceding five years, it was their principal residence.  The IRS argued that since they had converted the property to a rental unit prior to the short sale, it was no longer their principal residence.  The Court considered this a difficult issue.  It therefore sidestepped it by going on to the question of whether the short sale was one or two transactions.   It was one.  The short sale was coordinated with the bank and could not have gone forward unless the bank agreed to release its deed of trust from the property.  It was nothing more than a substitution for a foreclosure.  Thus the Simonsens erred in treating the short sale as two transactions.  Since the loan was nonrecourse, the amount realized was the amount of the debt, or $555,960.

This lead to the question of whether there was gain or loss on the short sale.  The Court noted something that the parties had overlooked:  although when a property is converted to a rental unit its basis is the value at the time of the conversion, under Treas. Reg. §1.165-9(b)(2), the value at the time of conversion is only used to compute loss.  To compute gain, you use the taxpayer’s adjusted cost basis.  The amount realized from the sale (the $555,960 owed on the note) was more than property’s fair market value at the time of conversion but less than the Simonsens’ adjusted cost basis.  So what happens when the amount realized from the sale is more than the basis used to compute loss but less than the basis used to compute gain?  As noted by Judge Holmes, this is a conundrum that only a tax lawyer could love.  There were no cases on point, but there was an analogous situation under the gift tax regulations.   A donee’s basis in property acquired by gift is the donor’s basis.  Under the regulations, where the donee sells the property, she computes gain using the donor’s basis and loss using the lesser of the donor’s basis and the fair market value of the property on the date of the gift.  The regulations provide that if the sale price falls between the donor’s basis and the value on the date of the gift, there is neither gain nor loss.  The Court found this a logical way to resolve the issue of whether there was gain or loss.

This left the issue of penalty.  The Court found that the Simonsens were not liable for the accuracy penalty.  First, the IRS failed to meet its burden of proving that it complied with the requirement for written managerial approval before issuance of the notice of deficiency.  Even if it had, the Court found that the taxpayers acted with reasonable cause and in good faith.  First, while Wells Fargo issued a Form 1099-C for cancellation of debt income, the title company issued a Form 1099-S for the sale of the property.  This supported their belief that there were two transactions.  Second, the IRS had not issued any regulations addressing the Mortgage Debt Relief Act, case law was scarce and it was not clear what “principal residence” means for purposes of the Act.  Additionally, the IRS pamphlets on cancellation of debt indicate that a basis adjustment is only necessary if you continue to own the property after the debt is cancelled.  The Court therefore found “that the Simonsens’ 2011 reporting errors were the result of an honest misunderstanding of the law that was reasonable considering their lack of tax knowledge, the complexity of the issues, and the information returns that they received. And we are convinced, based in large part on Christina’s honest and believable testimony, that the Simonsens acted in good faith.”

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.