Tax Court Resolves a "Kind of Conundrum Only Tax Lawyers Love" in Sale of Rental

In the case of Simonsen v. Commissioner, 150 TC No. 8, the Tax Court reaffirmed its previously stated position regarding a short sale when a nonrecourse debt is involved.  As well, for the first time the Court also addressed the reportable gain/loss on a property converted to rental use that was sold for less than its original cost but more than its date of conversion fair market value.

The couple in question had purchased a townhouse in San Jose in 2005 for $695,000.  They lived in that home for five years, during which the real estate crisis hit.  In 2010 they relocated to Southern California and began renting the townhouse.  At the time it was converted to a rental the fair value had declined to $495,000.

The only loan outstanding on the townhome was the original mortgage from Wells Fargo Bank.  Under California law such a mortgage on a residence is a nonrecourse debt. That is, the bank has no recourse if the debt is not paid except to take back the property securing the debt, in this case the San Jose townhome.

In late 2011 the couple entered into a short sale to rid themselves of the debt.  Wells Fargo agreed to release the lien on the property in exchange for the cash from the sale ($363,000) and agreed that the couple would not be held liable for the remaining $219,270 due on the debt.  A Form 1099-S was issued by the title company for the $363,000 of sales proceeds and the bank issued a Form 1099-C showing $219,270 of debt cancellation of income.

Relying on those 1099s, the taxpayers reported a loss on the disposition of their rental based on the fair value reduced by depreciation claimed of $11,000.  They reported the cancellation of debt income as being excluded from income as cancellation of qualified residence debt under IRC §108(a)(1)(E).  In the end, they claimed a loss on the sale of the rental of $70,000 and no income from cancellation of indebtedness.

The IRS objected to this treatment.  First, the IRS argued that, since this was a nonrecourse debt, there was only a single sale transaction (for $555,960, the outstanding balance of the mortgage when the short sale took place).  At that sales price there clearly would be no loss on disposition (though the issue of whether there would be a gain is one we’ll look at later).

Generally, if a taxpayer loses a property via foreclosure to a lender holding a debt for which the lender can seek recourse from the borrower, the sales price for computing gain/loss is limited to the fair value of the property foreclosed if that is insufficient to pay off the debt.  But if the mortgage in question is nonrecourse, the entire debt is treated as the sales price since the lender has no option but to accept the property in full payment of the debt. [Reg. §1.1001-2, IRC §61(a)(12)] In the latter case, there would be no cancellation of debt income.

Had the mortgage been foreclosed, there clearly would have been only a sale and no cancellation of indebtedness.  But this was a short sale, so would the result be the same?

The Tax Court had considered this issue previously.  In the case of 2925 Briarpark, Ltd. v. Commissioner, TC Memo 1997-298, affd. CA5, a partnership was attempting to have a reduction in the outstanding loan as part of a short sale treated as cancellation of indebtedness income rather than part of the sales proceeds.  The Tax Court, agreeing with the IRS, found “the transaction before us is the functional equivalent of a foreclosure, reconveyance in lieu of foreclosure, abandonment, or repossession.” 

The court pointed out that, unlike cases where the property owner continues to hold the property after a lender agrees to reduce the principal on a nonrecourse debt (which is treated as a cancellation of debt under IRC §61(a)(12)), in a short sale both the reduction of debt and the transfer of the property to a third party are part of a single integrated transaction.  In the Briarpark case, the bank had agreed to a contingent release of its liens upon the property, assuming the sale closed, and the bank received the agreed upon amount.

Thus, the proper treatment appears to be that a short sale of a property subject to a nonrecourse debt would be treated in the same manner as if the property had been repossessed.  The entire balance of the loan, and not just the balance the lender accepted as part of the short sale, would be treated as the proceeds from the sale.

The Court found no reason to treat the Simonsens’ situation differently than the treatment in Briarpark.  As the opinion notes:

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.

But that leaves us with a problem to solve—if there is not a $70,000 loss on sale, what is the gain/loss on the sale of this rental?

Under Reg. §1.695-9(b)(2), special rules apply regarding basis when a taxpayer converts property from personal to business use.  As the Court notes in the opinion:

The parties agree that the Simonsens converted their townhouse to a rental property in September 2010. When a taxpayer does this, his adjusted basis in the property to calculate the amount of any loss changes. See sec. 1.165-9(b)(2), Income Tax Regs.; see also Heiner v. Tindle, 276 U.S. 582, 586 (1928). There's a regulation that we have to follow here. Section 1.165-9(b)(2), Income Tax Regs., tell us to compute a loss using an adjusted basis that is the lesser of: (1) the taxpayer's existing adjusted basis or (2) the property's fair market value at the time of conversion. The parties agreed to this number — they stipulated that the fair market value of the Simonsens' home was $495,000 when they converted it to a rental property.

The IRS and the parties assumed that this became the basis of the property, and thus the IRS argued that now there was a gain on disposition.  But the Tax Court found the parties had overlooked an obvious but easy to miss point—that regulation only states it applies in computing a loss on disposition.  The new IRS assertion was that there was a gain on the disposition of the property.

If that regulation does not apply, then the “regular” basis rules would apply.  In this case that would mean we’d use the taxpayers’ original cost ($695,000) reduced by depreciation allowed or allowable (they had claimed $11,000).  Taking their depreciation figure as correct, that would create an adjusted basis of $684,000.  The sales price would be $555,960 which would lead to a loss of $128,040.  But now Reg. §1.165-9 would inject itself back into the equation since this is now a claimed loss—and thus it applies, aside from the minor problem that once we do the calculations it no longer applies.

The Court observes that “[t]his 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.”

Thus, the Court now must determine how the law should apply in this case.  To do so, it looks to a similar situation that occurs when a donor gifts property when its fair value is less than the donor’s basis:

The Code tells us that the person receiving a gift generally takes the donor's basis in the gift as his own. 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. Id.; sec. 1.1015-1(a)(1), Income Tax Regs. So far, so similar to the Simonsens’ situation. 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. “The no gain or loss answer derives from a conceptual vacuum when the asset is sold for an amount less than its gain basis and more than its loss basis.”  Arthur B. Willis et al., Partnership Taxation 4-73, para. 4.03[2][c] (8th ed. 2017) (discussing the same odd result that must occur under section 1.165-9(b)(2), Income Tax Regs.) 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.

This result is not surprising and is one that this author has taken multiple times in the past, especially in cases like this one that arose in the aftermath of the real estate crisis.

But you might ask—shouldn’t they have to pay tax due to having claimed depreciation?  The answer is no—the depreciation affects the computation of adjusted basis, but even after reducing the beginning unadjusted basis either under the “regular rule” (so we start with cost) or using the special FMV rule of Reg. §1.165-9(b)(2) we still end up with a basis for gain that is more than the proceeds and a basis for loss that is less than the proceeds.

The Court effectively notes this, since the issue of “allowed or allowable” depreciation wasn’t directly at issue here, so the court notes:

Adjusted basis is typically what a property owner paid for the property plus what he later spent to improve it, minus allowed or allowable depreciation. Secs. 1011(a), 1012(a), 1016. We'll ask the parties to compute appropriate allowed or allowable depreciation, but we think they’ll find that it doesn't make a difference.