What. A. Year.
When tax geeks arose from their slumber on January 1, 2018, we were greeted by a strange and unfamiliar world. Gone were personal exemptions, Section 199, and 50% bonus depreciation. In their place were a doubled standard deduction, Section 199A, and 100% bonus depreciation. These changes, in addition to countless others, were the end result of a whirlwind legislative process that overhauled our beloved Internal Revenue Code in a mere seven weeks, an act of Congressional hubris that tax professionals will rue for years to come.
As a result of this sweeping new legislation, ever since the calendar turned to 2018, all of our attention has been focused on getting up to speed on the new law. But while we've been up to the strained waistline of our pleated Dockers in Opportunity Zones and interest limitations, the century worth of tax law that existed prior to the Tax Cuts and Jobs Act has been completely ignored. Thousands of provisions survived the recent round of reform, and throughout 2018, many of those provisions have found their way into the Tax Court, where disputes between taxpayers and the IRS have ended in all-important judicial precedent.
But anyone who claims to have kept up with the Tax Court in 2018 is flat-out lying. Save for the occasional Wesley Snipes appearance, most of the cases decided by the court in 2018 have gone largely unnoticed, lost to the piles of proposed regulations that have been published on the new law.
And that, quite frankly, is unacceptable. We can't be like Homer, who once lamented that every time he learned something new, it pushed some old stuff out of his brain. We've got to do it all: get a grasp on the new law, while continuing to master the old. After all, Judge Holmes ain't offering up that word play for no one to read it.
So let's do this. Over the next twelve weeks, lets dissect one Tax Court case from each month of 2018. Keep in mind, these cases are not necessarily the most important decisions of each month, but rather the ones that I believe to be most useful to your humble workaday tax pro. If you disagree, write your own damn list.
For January's case, we covered Conner v. Commissioner, T.C. Memo 2018-6, a case addressing whether the sale of real estate generated ordinary income or capital gain.
For February, check out Meruelo v. Commissioner, TC Memo 2018-16, in which we discussed the many ways shareholders in an S corporation screw up trying to obtain "debt basis."
On to March.
March: Simonsen v. Commissioner, 150 T.C. 8
What Makes it Special?
Do you remember 2012? No, not the unwatchable Cusack flick, I meant the year. I remember it quite well. The Patriots choked in the Super Bowl. The final season of Breaking Bad was released. And the band Fun. managed to release an album where every song sounded exactly the same. Oh, and I'm pretty sure one of my kids was born that year. Good times, all.
It was also an important year for me at work. It was during 2012 that I mustered the courage to overcome the fact that I'm terrified of people and try my hand at teaching, a decision that would dramatically alter the trajectory of my career. On that maiden voyage, I spoke to a few hundred people at the CCH User Conference about a topic that was hot and heavy at the time: the tax implications of foreclosures and short sales.
As a result, Section 1001, Section 108, Crane, Tufts, and Helvering v. Hammel will always hold a special place in my heart. And if that sentence means nothing to you right now, well...it will soon.
Because for our March case, we're going to break down Simonsen v. Commissioner, a case that touches on one well-worn issue that taxpayers continue to screw up -- how do we treat the sale of property in a foreclosure or short sale? -- as well one issue of first impression -- what basis do we use for determining gain or loss when we sell a rental property that used to be a primary residence? There's a lot to learn, so let's get to it.
Facts in Simonsen
The critical facts in Simonsen are fairly easy to follow, because all you need to remember are numbers. Here goes...
2005: The Simonsens bought a house for $695,000, borrowing $556,000 from a bank to make it happen. The mortgage was made on a "nonrecourse basis." (Much) more on this later.
2010: They moved out and turned the house into a rental at a time when the fair market value (FMV) of the house had dropped to $495,000.
2011: They sold the house in a "short sale" for $336,000. In a short sale, the bank must agree in advance to allow the homeowner to sell the house to a third party, even though the sale will fetch less than the amount the seller owes the bank. On top of that, the bank will also agree to forgive any remaining debt the seller owes the bank after turning over the purchase price. As a result, the Simonsens immediately paid the $336,000 over to the bank in partial satisfaction of the $556,000 mortgage. The bank "forgave" the remaining balance of the debt of $220,000 ($556,000 less the $336,000 sales price). The bank then issued the Simonsens a Form 1099-C showing cancellation of debt income of $220,000.
Taxpayer Position
On their 2011 tax return, the Simonsens reflected a loss on the sale of a rental property of $159,000 (the sales price of $336,000 less the basis of the house, which the Simonsens determined to be the FMV of the home at the time of the conversion to a rental property, or $495,000). In addition, they reported $220,000 of cancellation of debt income, but then excluded that debt from income under Section 108(a)(1)(E), the exclusion available for cancellation of debt income related to a principal residence. Don't worry, we'll go through ALL of these things in detail.
IRS Position
The IRS argued that because the mortgage was nonrecourse, there could be no cancellation of debt income on the sale. Instead, the amount realized on the sale was $556,000, the full balance of the nonrecourse debt. And because the Simonsens' basis in the home was admittedly $495,000 after its conversion to a rental property, they should have recognized GAIN of $61,000 rather than a loss of $159,000.
Relevant Law
As I said, the reason I chose this case is because it contains a treasure trove of titillating tax topics: cancellation of debt income, nonrecourse versus recourse debt, the tax consequences of short sales and foreclosure, the definition of a "principal residence," and the computation of a taxpayer's basis in a home that has been converted from a residence to a rental. Let's address those one by one, shall we?
Cancellation of Debt Income (COD)
Let's introduce the concept of COD income with a very simple illustration. Assume I loan you $500 (I won't). While you might feel wealthier, you're really not. Because while you now have an extra $500, you also have an offsetting obligation to pay me back my money, or else risk getting your thumbs broken by my ol' man, Angelo "The Fish" Nitti. So your assets went up, but so did your liabilities: your net value remained the same. Thus, in the eyes of the IRS, you have not enjoyed an accession to wealth, and the $500 I loaned you does not represent taxable income.
But what if after a week of watching you consume nothing but expired mustard packets, I say to you, "you know what...you clearly need the $500 more than I do. Keep it. It's yours,"...well, now the game has changed. You have $500 that you didn't have before, with no offsetting obligation to pay me back. Now, you have been enriched; you have enjoyed an accession to wealth. And since the IRS is in the habit of taxing accessions to wealth, under an old case called Kirby Lumber, and then later codified in Section 61(a)(12), the moment I "forgive" your obligation to repay me my $500, you have $500 of taxable income.
Make sense?
Exclusions from Income for Certain COD Income
The Code and regulations wouldn’t stretch to tens of thousands of pages without containing a healthy amount of exceptions to the general rules contained therein, and the area of debt forgiveness is no different.
The Code is generally structured so as not to punish you if you can't pay your debts; in other words, the tax law is not intended to be punitive. It follows, then, that if you are so financially strapped that you cannot pay your lenders, it is unlikely that you have the means to pay the tax resulting from including the debt's forgiveness in income.
That's where Section 108 steps in to address a cancellation of debt; it permits a taxpayer who has debt forgiven to enjoy a "fresh start" by deferring the impact of the forgiveness until a future year. It works like so:
Section 108 provides five primary exceptions to the general rule that COD generates taxable income, including:
- Section 108(a)(1)(A), which provides that a taxpayer in chapter 11 bankruptcy does not recognize COD income when debt is forgiven as part of the bankruptcy,
- Section 108(a)(1)(B), which provides that an insolvent taxpayer (debt exceeds the FMV of assets) does not recognize COD to the extent the taxpayer is insolvent prior to the forgiveness,
- Section 108(a)(1)(E), which provides that before December 31, 2017, a taxpayer could exclude up to $2,000,000 of COD income when a mortgage is forgiven on the taxpayer’s principal residence,
- Section 108(a)(1)(D), which provides that, subject to limitation, no COD is recognized when debt is forgiven that constitutes, “qualified real property business indebtedness,”
- Section 108(a)(1)(C), which provides that no COD is recognizes upon the forgiveness of “qualified farm indebtedness.”
While these Section 108 provisions are almost always referred to as “exclusions,” they are more accurately described as deferrals of the income. The intent of Section 108 is not to free a taxpayer from the obligation to pay tax on debt that was forgiven; rather, it is merely to give a taxpayer a breather while it gets back on its feet. The taxpayer should be required to pay the tax on the forgiven debt as soon as is financially reasonable, however.
Section 108 accomplishes this goal by mandating a trade: a taxpayer who excludes COD under one of the afore-mentioned provisions must in turn reduce certain tax attributes — such as net operating losses (NOL), capital loss carryforwards, or the depreciable basis of property — by the amount of the forgiveness. Thus, in theory (though not always in practice), the forgiveness will eventually come home to roost in a later year when the taxpayer has fewer attributes available to either offset income or create tax depreciation, and will therefore pay the tax that was deferred at the time of the original COD exclusion.
I write "not always in practice" because sometimes, a taxpayer will never recognize some or all of the income previously deferred upon the exclusion of COD. This is because a taxpayer's exclusion from COD is not limited to its attribute reduction. To illustrate, if a bankrupt taxpayer is forgiven of $100 of debt when its only tax attribute is a $70 NOL, the taxpayer is still permitted to exclude the entire $100 of debt despite the fact that only $70 of tax attributes will be reduced. This is often referred to as the "black hole" of attribute reduction, and represents one of the few areas of the tax law where a taxpayer can unequivocally come out ahead, so much as a bankrupt or insolvent taxpayer can ever "come out ahead."
Section 108(a)(1)(E) Exclusion
As noted above, if you recognized COD related to a principal residence prior to 2018, you could exclude up to $2 million of the COD income. But what exactly is a "principal residence?" Section 108 refers to Section 121, which provides an exclusion from gain upon the sale of a home that was owned and used for two of the previous five years as your "principal residence." Section 121, however, does not define the term "principal residence." This is important in the Simonsen case, because while the home was owned and used as the principal residence in two of the five years leading up to the sale, it was not the principal residence on the date of sale. Does it matter? To use Section 108(a)(1)(E), did the house need to be your principal residence on the date of sale, or merely in two of the prior five years. This issue had never been in front of the Tax Court before, so this would be a case of first impression.
Now, you might ask the question, "If the Simonsens excluded the $220,000 of COD income, wouldn't they have to reduce their attributes -- i.e., the basis of the house -- prior to the sale? So wouldn't the COD just have been converted into gain on the sale of the house?" Great questions, both. But interestingly enough, that's not how it would work. Through a quirk in the tax law, when you exclude COD income under Section 108, you are required to reduce your attributes on the first day of the next tax year. And because the Simonsens didn't own the house on the first day of the next tax year -- remember, they'd sold it -- they would get away with one: they'd get to exclude $220,000 of COD income, without a corresponding reduction in the basis of the home.
When Does a Sale of Property Give Rise to COD?
Now this is going to seem blindingly simple, but it's really, really important: in order to use one of these Section 108 exclusions, you have to first recognize COD income. You can't have one without the other. And that, ultimately, is the thrust of the Simonsen case: we know that if I loan you $500 and later tell you not to repay me, you have taxable COD income. But when do you recognize COD upon a short sale of your primary residence?
Before we can address that particular issue, we have to understand a bit about the nature of mortgages...
Nonrecourse and Recourse Mortgages
Unless you came over on a different boat than I did, you're not paying for your house with cash. You're borrowing. And whenever you borrow to buy real estate, there are two distinct types of mortgage: nonrecourse and recourse.
Warning: we are about to spend a few thousand words defining "nonrecourse" and "recourse" liabilities and the tax consequences that arise when a property subject to each type of liability is sold. If you work in the partnership realm, however, you might already be familiar with these terms: after all, on every Schedule K-1 you pass out to a partner, you are required to allocate the liabilities of the partnership among the partners. This is because, under Section 752, a partner gets basis for his or her share of all of the liabilities of the partnership. And included among the different types of liabilities to be allocated are "nonrecourse" and "recourse" debts.
But here's the thing: in Simonsen, we're not dealing with partnership liabilities. Rather, we are dealing with the sale of property, which is governed by Section 1001. And stay with me here...the definition of a liability as "nonrecourse" or "recourse" for purposes of Section 752 is ENTIRELY DIFFERENT than the definition of a liability as "nonrecourse" or "recourse" for the purposes of Section 1001. This is why our tax law is a disaster. If you're interested in the difference, and even the interplay between the two, first things first, I'd suggest you find a hobby. But if that doesn't work, you're welcome to read about it here.
Under Regulation Section 1.1001-2(c), a mortgage is nonrecourse if the borrower is not personally liable for the debt and the creditor's recourse is limited to the secured asset, and a mortgage is recourse if the borrower is personally liability for the debt. But what does that really mean?
Once again, a simple illustration will suffice. Assume you're the borrower. A mortgage is nonrecourse if the only option the lender has should you default on the loan is to seize the property and sell it at a foreclosure auction, applying the proceeds against the debt. Should the proceeds fail to satisfy the full balance of the mortgage; well, that’s the lender’s problem. Your obligation is extinguished in full when the property is sold at auction. In other words, with a nonrecourse mortgage, the lender bears the risk of loss if the property declines in value.
Ex: Bank loans A $1,000,000 to purchase a residence. A purchases the residence, and watches the value plummet to $500,000 at a time when A has only paid the mortgage down to $900,000. A decides to stop paying the loan entirely, because why pay $900,000 for something worth only $500,000? Under the specific terms of the loan, assume the only option the bank has is to seize the house, sell it for its FMV of $500,000, and apply the $500,000 against the $900,000 outstanding loan balance. The bank cannot pursue A for the additional $400,000 deficiency. Thus, this mortgage was a nonrecourse mortgage -- the bank is out $400,000, and A gets away with one.
Conversely, if the mortgage is recourse, the lender can not only seize and sell the property, but they can also purse the borrower for any excess deficiency that remains after the foreclosure sale.
Ex: Same facts as the previous example, except that under the specific terms of the mortgage, if A stops paying the loan, not only can the bank seize the house, sell it for $500,000 and apply that $500,000 against the $900,000 loan balance, the bank can also bang on A's door in pursuit of the remaining $400,000 deficiency. Thus, this mortgage was a recourse mortgage because A, not the bank, bears the risk of loss when the property value declines. A now has to dig into his pocket for an extra $400,000, and pay the bank $900,000 for something worth only $500,000.
Tax Implications of a Foreclosure or Short Sale
Next, we have to make sure we understand the nature of a foreclosure or short sale. They are essentially the same thing: when a lender isn't being repaid on a mortgage, the lender has options. First, the lender can seize the property and sell it at auction in a foreclosure sale. Alternatively, perhaps the homeowner finds someone that wants to buy the house. If the house is worth far less than the loan balance (it will be), then the lender has to agree to the sale.
Let's be clear on this, in the case of a foreclosure sale, while you might not think of it as a "sale" because it is not a voluntary action taken by the homeowner, but rather a forced action at the behest of the lender, for tax purposes a foreclosure is treated exactly the same as a voluntary sale by the buyer (See: Helverling v. Hammel). And since a short sale -- which I described in the "facts" section above -- is in fact a voluntary sale, those transactions are obviously taxed as a sale as well. This means that in both cases, we need to know the amount realized on the sale and the adjusted basis of the home in order to compute the gain or loss on the sale pursuant to Section 1001. And while it's very common for the "amount realized" to be the subject of controversy in a foreclosure or short sale, Simonsen is the rare case where the Tax Court had to determine not only the amount realized on the home, but also its adjusted basis.
Let's keep moving forward.
Amount Realized, Nonrecourse Mortgage:
Under the Section 1001 regulations, the amount realized on a sale includes any liability from which a taxpayer is relieved upon the disposition of the property. Think about what that means in the context of a nonrecourse liability: going back to my example above, if the home is worth $500,000 and the nonrecourse mortgage is $900,000, if the house is sold in a short sale for $500,000, how much of the debt is extinguished in the deal? The answer, of course, is all of it. Because with a nonrecourse mortgage, the only option the lender has is to seize and sell the property for its $500,000 value. The lender can't come after you for the remaining $400,000. So it follows that once the house is sold, you have washed your hands of the entire $900,000 loan balance, even though the bank only got $500,000 for its efforts.
While that may sound great, being "relieved" of that $900,000 debt has serious tax consequences. Because under the Section 1001 regulations -- as well as Supreme Court decisions in Crane and Tufts -- when you sell property subject to a nonrecourse mortgage, the purchase price of the property is completely irrelevant. Instead, the borrower is treated as if they sold the property for the entire balance of the nonrecourse mortgage, which in a foreclosure or short sale situation, will always be greater than the selling price of the house.
It makes sense: once you sold the house, you were "off the hook" for the full $900,000 loan balance. That loan was extinguished, and the precedents cited above provide that when you sell a property subject to a loan and the loan is extinguished, the loan is treated as part of the sales price. And as Tufts made very clear, this is the case even when the value of the house is less than the nonrecourse loan balance. So going back to my example, if you sell a house in a short sale for $500,000 when the balance of the nonrecourse loan is $900,000, you are treated as having sold the house for $900,000.
In that situation, what is noticeably absent? Any COD income, that's what. You CANNOT have COD income when you sell a house that is subject to a nonrecourse mortgage in a foreclosure or short sale, and it totally makes sense for two reasons:
- Because the full balance of the debt was included in your sales price, you haven't been "forgiven" of anything, and
- You can't have "forgiveness of debt" when the lender never had any right to pursue the debt in the first place.
The second point is the key. Remember, in my example, while the house was worth only $500,000 and subject to a $900,000 debt, because the loan was nonrecourse, the lender never had the ability to pursue you for the $400,000 deficiency. And since they had no right to pursue it, they can't well "forgive" it now, can they?
In summary, when you sell property subject to nonrecourse debt, the consequences are extremely straightforward. The full amount of the debt is included in your sales price, and there is NO COD income.
Amount Realized, Recourse Mortgage:
When you sell a piece of property subject to a recourse mortgage, however, the consequences are a bit different, and decidedly more complex. And they should be. Here's why.
Remember, when you sell property subject to a recourse mortgage in a foreclosure or short sale, you are not extinguished of the full liability. Rather, the lender has every right to beat down your door in an attempt to collect the remaining deficiency after the house has been sold. So using our numbers, if you sell for $500,000 when the recourse loan balance was $900,000, after the sale, you are not off the hook for the full $900,000. Instead, you are only off the hook for $500,000, and now there's the little matter of the $400,000 you still owe the lender to deal with.
This is why, under the principles established many years ago by the Tax Court in Aizawa, upon the foreclosure or short sale of a property subject to a recourse mortgage, the transaction must be bifurcated.
In the first part of the transaction, you are treated as if you sold the property for an amount equal to its actual selling price. [See Treas. Reg. §1.166-6 and Community Banks ].
Then, there's a "wait and see" moment -- is the remaining deficiency paid or forgiven? If you pay the deficiency, no further gain or loss occurs, because you have settled the outstanding debt, and that is not a taxable event. If, however, the lender forgives the deficiency -- which is usually what happens because you can't get blood from a stone -- you recognize COD income for the amount of the forgiveness.
In summary, only a sale subject to a recourse mortgage can give rise to COD, because only in this context does the lender even have the right to collect any remaining deficiency after the sale, and so it follows that this is the only context in which that debt can be forgiven. And since COD can only be recognized upon the sale of property subject to a recourse mortgage, -- and this is really the biggest takeaway of this discussion -- the exclusions for COD income found in Section 108 that we discussed above will only be relevant when dealing with a recourse mortgage.
Basis of Property Converted from Residence to Rental
When you convert a residence to a rental, your basis changes. Reg. Section 1.165-9(b)(2) provides that your new basis is the lower of the original basis of the home, or the FMV at the time of the conversion. Easy enough. Or is it? We'll see.
Tax Court Opinion
Now that we understand the law, let's rehash the facts.
- 2005: principal residence purchased for $695,000, borrowing $556,000 on a nonrecourse basis.
- 2010: converted the house to a rental when FMV was $495,000.
- 2011: sold the house in a "short sale" for $336,000, and immediately turned that amount over to the bank in partial satisfaction of the $556,000 mortgage. The bank "forgave" the remaining balance of the debt of $220,000 ($556,000 less the $336,000 sales price) and issued the Simonsens a Form 1099-C showing cancellation of debt income of $220,000.
On their 2011 tax return, the Simonsens reported:
- loss on the sale of a rental property of $159,000 (the sales price of $336,000 less the basis of the house of $495,000).
- COD income of $220,000 that was excluded under Section 108(a)(1)(E).
The IRS denied the loss, arguing that because the loan was nonrecourse, the Simonsens actually sold the property for the loan balance of $556,000, and had a GAIN of $61,000 on the sale.
Who was right?
As you might imagine, the Tax Court made quick work of a couple of the issues.
The Simonsens were adamant that a short sale results in two separate transactions -- a sale or exchange for an amount equal to the sales price, and a subsequent forgiveness of any remaining debt -- even if the debt was nonrecourse. As we already established, however, this is simply not the case -- according to both the Section 1001 regulations AND the Supreme Court, when a sale occurs and the property is subject to a nonrecourse mortgage, there is only one transaction: a sale of the property for an amount realized equal to the entire balance of the nonrecourse debt. The Tax Court agreed:
We think the key point here is the complete dependence of Wells Fargo’s willingness to cancel the debt on the Simonsens’ willingness to turn over the proceeds from the sale of their home. The Commissioner’s view is consistent with the obvious realities of the transaction--that Wells Fargo had to reconvey the deed of trust for the sale to close, and that it would’ve been able to dictate the terms of the sale as long as it retained the deed of trust. Because Wells Fargo couldn’t collect on the debt once it reconveyed the deed of trust--it was nonrecourse debt after all--the debt forgiveness occurred when the sale closed. There was but one transaction.
As you'll note, the Tax Court placed no weight on the fact that the lender -- Wells Fargo, in this case -- reported as if the Simonsens had $220,000 of COD income by issuing them a 1099 in that amount. This is a reminder that your tax consequences are not fixed by the reporting of those involved, but rather, as you might imagine, by the correct result.
Having settled that fact, (most of) the rest of the case fell into place. The sales price was now set; it was the balance of the loan, or $556,000. And thus there could be no COD, because as we've discussed, all of the debt was included in the sales price, so none of the debt was "forgiven" (nor did the lender have any RIGHT to forgive the excess deficiency). And since there was no COD, the Tax Court didn't have to decide whether the Simonsens could have availed themselves of Section 108(a)(1)(E), which means that particular issue -- does the home need to be your principal residence at the time of the debt forgiveness, or just meet the 2 of 5 year Section 121 test to exclude up to $2 million of COD -- remains unsettled.
There was one final piece of the puzzle: what was the appropriate basis of the house when it was sold? We know that when a taxpayer converts a principal residence to a rental, the basis of the house is the LESSER of the original basis or the FMV of the house at the time of the conversion. And we know that both the Simonsens and the IRS agreed that the FMV of the house was $495,000 on the date of conversion. So we're all set, right? The sales price was $556,000, the basis was $495,000, so the Simonsens should have gain of $61,000, no?
No. As the Tax Court correctly pointed out, this determination of basis upon conversion is only relevant for determining a subsequent loss on the sale of the home. The purpose is obvious: it prevents a taxpayer from converting pre-conversion depreciation on a home -- which would never be deductible because those losses are personal -- into a loss from the sale of rental property. To illustrate, we know the original basis of the house was $695,000. But by the time it was converted to a rental, the FMV was only $495,000. If the Simonsens were permitted to use the $695,000 original basis, if they subsequently sold the house for, say, $300,000, they would recognize a $395,000 loss, even though $200,000 of the loss in value occurred while the house was a personal asset. Thus, to avoid this result, the appropriate basis for determining loss is $495,000, not $695,000.
Basis, after a conversion from a residence to a rental, however, is a chameleon. We only use that lower FMV as the basis if, as discussed above, the property is subsequently sold for an amount LESS THAN the FMV on the conversion date. If the house is sold for a gain -- i.e., an amount GREATER THAN the higher, original basis on the conversion date -- than the basis used is the original basis. In other words, the IRS won't punish a taxpayer and make them pay tax on phantom depreciation that happened PRIOR to a conversion from a residence to a rental when that loss in value is subsequently recovered prior to sale.
But here, the deemed sales price of the house was $556,000, the full balance of the nonrecourse loan. This is smack in the middle of the basis of the house when originally purchased that is used to compute gain -- $695,000 -- and the basis at the time of conversion to a rental used to compute loss, or $495,000. As you can see, with a purchase price equal to the debt balance of $556,000, if the basis used to compute gain of $695,000 were used, there would be NO GAIN; rather, there would be a loss of $139,000. And if the basis used to compute loss of $495,000 were used, then there would be no loss; rather, there would be gain of $61,000.
So what do we do? Let's let Judge Holmes explain:
This is the kind of conundrum only tax lawyers love. And it is not one we’ve been able to find anywhere in any case that involves a short sale of a house or any other asset for that matter. The closest analogy we can find is to what happens to bases in property that one person gives to another. The Code tells us that the person receiving a gift generally takes the donor’s basis in the gift as his own under Sec. 1015(a). But what if such a gift has a value lower than that basis when it is given? The answer that the Code and regulations give us for gifts is that the donee uses the lower fair market value to compute a loss but the donor’s basis to compute a gain. But what to do when a donee sells the gift at a price between these two possible bases? The regulations on gifts tell us: Section 1.1015-1(a)(2), Income Tax Regs., provides that there’s no gain or loss. We know this regulation is for gifts and not converted personal residences. But we think it is logically coherent and adopt it as our holding today. We therefore conclude that the Simonsens realized neither a gain nor a loss on the short sale of their home.
How about that? Under the gift tax rules, just like the residence-to-rental rules, when you receive property with a FMV less than the original basis of the property, you use the lower FMV of the property to determine a subsequent loss on the sale of the property. But unlike the residence-to-rental rules, the gift rules tell us exactly what happens when you later sell the gifted property for more than the FMV at the time of the gift, but less than the basis at the time of the gift: THERE IS NO GAIN OR LOSS.
And even though the gift rules do not directly apply to the sale of a rental property, the court felt that logic ruled the day, and the same result should arise. So after all that: the taxpayer claiming a $159,000 loss on the sale, the IRS arguing a $61,000 gain, the end result was....nothing. No gain. No loss.
Conclusion
The biggest take away from Simonsen is just how difficult it can be to navigate the tax law. After all, if you're a regular Joe Taxpayer, and a bank hands you a Form 1099 stating that you've got cancellation of indebtedness income of $220,000, well...you're damn sure going to report $220,000 of COD income. And if there's an exclusion to the income that your tax prep software alerts you to, well...you're damn sure going to use that as well. What you're NOT going to do, is this:
- understand that there is a difference in tax treatment depending on whether your mortgage was nonrecourse or recourse,
- understand that there are DIFFERENT definitions of nonrecourse and recourse debt depending on which provision of the Code you're applying them to,
- figure out which definition applies to you, and then identify the proper tax consequences, even though those consequences run contrary to the manner in which a bank reported the transaction to both you and the IRS,
- come to the realization that determining the basis of your home, given your specific facts, is an issue that HAS NO ANSWER, but that somehow you need to come up with an answer on your own.
Tackling these issues is only marginally easier if you're Joe Tax Adviser, but only if you're constantly staying educated and reading cases juuuust like this one. See you next week.
