150 T.C. 201
Tax Ct.2018Background
- Karl and Christina Simonsen purchased a San Jose townhouse in 2005 with a purchase-money loan secured by a deed of trust; the loan was nonrecourse under California law.
- They converted the property to a rental in Sept. 2010 and sold it in a short sale in Nov. 2011 for $363,000; Wells Fargo agreed to reconvey the deed of trust and forgive the remaining loan balance.
- Wells Fargo issued Form 1099-C reporting cancelled debt (~$219,270) and a title company issued Form 1099-S reporting sale proceeds of $363,000; the Simonsens reported a large deductible loss and excluded COI income under the Mortgage Forgiveness Debt Relief Act on their 2011 return.
- Commissioner audited, treated the short sale and debt forgiveness as one sale-or-exchange, included the discharged nonrecourse debt in the amount realized, disallowed the reported loss, and asserted a §6662 accuracy-related penalty.
- Tax Court found the short sale and debt forgiveness were one transaction; amount realized included discharged nonrecourse debt, resulting in an amount realized ($555,960) between the loss-basis ($495,000) and gain-basis (~$695,000), producing neither gain nor loss under the adopted analogy to gift-basis rules.
- The Court denied the §6662 penalty because the Commissioner failed to produce evidence of required supervisory approval and, alternatively, the taxpayers had reasonable cause and acted in good faith.
Issues
| Issue | Simonsen's Argument | Commissioner Argument | Held |
|---|---|---|---|
| Whether the short sale and subsequent debt forgiveness constituted one transaction or two (sale + COI) | Sale and forgiveness were separate; treated sale for $363,000 and excluded COI under §108(h)(1)(E) because home met "principal residence" test | Short sale and debt forgiveness were a single sale-or-exchange; discharged nonrecourse debt is part of amount realized under §1001 and regs | Single transaction: sale and debt discharge are one sale-or-exchange; discharged nonrecourse debt included in amount realized |
| Whether discharged nonrecourse debt is included in amount realized | Should not be included; results instead in COI income (excluded under §108) | Included in amount realized per precedent (Tufts, Crane) and regs; thus not COI | Included: amount realized = cash proceeds + discharged nonrecourse debt = $555,960 |
| Whether the taxpayers realized a gain or loss on the short sale given conversion-to-rental basis rules | Reported large loss based on converted adjusted basis; argued no basis reduction for COI exclusion | Disallowed reported loss; amount realized included discharged debt, so compute gain/loss under §1001 and reg. 1.165-9(b)(2) | Amount realized fell between the lesser basis for loss ($495,000) and the greater basis for gain (~$695,000); by adopting the gift-basis analogy, court held there was neither gain nor loss |
| Whether §6662(a) accuracy-related penalty applies | Taxpayers acted in good faith and reasonably relied on information returns and IRS guidance; reasonable cause | Penalty asserted for substantial understatement; Commissioner produced amount but not required supervisory approval for the penalty | No penalty: Commissioner failed to meet burden to produce supervisory approval under §6751(b); alternatively, taxpayers established reasonable cause and good faith |
Key Cases Cited
- Crane v. Commissioner, 331 U.S. 1 (disposition of property encumbered by nonrecourse debt can produce amount realized that includes the debt)
- Commissioner v. Tufts, 461 U.S. 300 (amount realized on sale of property subject to nonrecourse obligation includes outstanding obligation)
- 2925 Briarpark, Ltd. v. Commissioner, 163 F.3d 313 (5th Cir.) (short sale treated as single transaction; sale and lender forgiveness functionally equivalent to foreclosure/reconveyance)
- Coker v. JPMorgan Chase Bank, N.A., 364 P.3d 176 (Cal. 2016) (discussion of short-sale mechanics and lender control over sale while trust deed retained)