Tax Court decides tax consequences related to a short sale of property

Tax Hot Topics newsletter The Tax Court held in Simonsen v. Commissioner, 150 T.C. No. 8 (2018), that a couple did not incur income when they entered into a short sale that resulted in their remaining loan balance being forgiven.

In Simonsen, a taxpayers, a married couple (the Simonsens) purchased a townhouse in 2005 for approximately $695,000, which was financed with a nonrecourse loan from Wells Fargo Bank. The townhouse was the Simonsens’ principal residence until 2010, at which point they converted it into a rental property. In 2011, the Simonsens entered into a short sale of the townhouse, which they had to negotiate with Wells Fargo and a third-party buyer. The proceeds from the short sale were $363,000. All of the proceeds were applied to their loan from Wells Fargo, and the remaining loan balance after applying the proceeds was $219,270. That amount was forgiven by the bank.

The Simonsens filed their tax return including a $216,495 loss from the sale of the townhouse and cancellation of debt (COD) income for the amount of the loan that was forgiven. They took a position to exclude the COD income under Section 108(a)(1)(E) because the townhouse had been their principal residence.

The Tax Court held that the short sale and the discharge of their debt should be treated as a single transaction similar to Briarpark Ltd. v. Commissioner, 163 F.3d 313 (5th Cir. 1999). The court also held that their amount realized was equal to the full amount of their remaining loan balance because the loan was nonrecourse under the seminal cases of Crane v. Commissioner, 331 U.S. 1 (1947) and Commissioner v. Tufts, 461 U.S. 300 (1983).

Finally, the court held that the Simonsens incurred no gain or loss related to the sale for tax purposes. Because the Simonsens converted the townhouse to a rental property in 2010, their adjusted basis for determining a loss was limited to its fair market value at the time of the conversion under Treas. Reg. Sec. 1.165-9. Because their adjusted basis under Treas. Reg. Sec. 1.165-9 was lower than their amount realized, the Simonsens did not incur a loss. Furthermore, the court held that the Simonsens did not incur a gain because their basis for determining a gain was higher than their amount realized. Notably, Treas. Reg. Sec. 1.165-9 only applied to limit their adjusted basis for determining whether they incurred a loss.

Andy Cordonnier
Washington National Tax Office
T +1 202 521 1502

Jeff Borghino
Washington National Tax Office
T +1 202 521 1532

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