Connections for Success



Is it a Gain or a Loss?
Anita S. Wescott

The U.S. Tax Court regularly hears cases regarding the proper tax treatment of property sales. Recently, though, the court addressed a real estate-related situation in Simonsen v. Commissioner that it described as a “conundrum only tax lawyers could love.”

IRS examines short sale

A couple bought a townhouse in California for nearly $695,000 in 2005, financing it with a mortgage that, under California law, was nonrecourse debt. In 2010, they moved and began renting the townhouse. By the time of its conversion to a rental property, the fair market value (FMV) had dropped to $495,000.

In 2011, the couple entered a short sale on the townhouse. The lender released its lien in exchange for the proceeds from the sale ($363,000) and discharged the remaining debt on the loan ($219,270). The taxpayers characterized the short sale and the debt forgiveness as separate transactions, resulting in two separate reportable items—a loss on the sale and cancellation of indebtedness income.

The IRS asserted that, because the mortgage was nonrecourse debt, it should be reported as a single sale transaction and the discharged debt should be included in the amount realized on the sale. As a result, no loss occurred. Thus, it assessed a tax deficiency of about $70,000 against the couple. The taxpayers appealed the decision to the Tax Court.

Tax Court weighs in

First, the court analyzed whether one or two transactions had taken place. A key determinant was the complete dependence of the lender’s willingness to cancel the debt on the couple’s willingness to turn over the proceeds from the sale.

The sale could not close unless the lender reconveyed the deed of trust. The lender could not collect on the remaining debt once it reconveyed the deed, because it was nonrecourse debt. So, the debt forgiveness occurred when the sale closed. The court, therefore, concluded that “there was but one transaction.”

Next, the court turned its attention to computing the gain or loss on that transaction. A loss exists only if the amount realized from a sale is less than the adjusted basis in the property.

Under tax regulations, the general rule is that the amount realized from the sale of property includes the amount of liabilities from which the seller is discharged as a result of the sale. The regulations further note that the sale of property that secures nonrecourse debt discharges the seller from the liability. That meant that the couple’s amount realized was the total loan balance at the time of the sale ($555,960).

The issue is that this amount falls between the basis used to calculate a loss ($495,000) and the basis used to calculate a gain ($695,000). In other words, the regulations directed the court to use a basis in calculating a loss that would result in a gain ($555,960 versus $495,000). However, the regulations also told the court to use a basis in calculating a gain that would result in a loss ($555,960 versus $695,000). The court ultimately decided that when a property is sold for an amount between the loss basis and the gain basis, neither a gain nor a loss is realized.

No penalties apply

In the end, the court concluded that the couple had lost the benefit of the loss deduction. However, on the positive side, the court also found that they were not liable for a 20% accuracy-related penalty because they had acted with reasonable cause and in good faith.

For more information, contact Anita Wescott at [email protected], or call her at 312.670.7444. Visit to learn more about our Real Estate Group.

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