Rental Property Short Sale

Hello and thank you for reading my question.

My client is currently under examination for their 2012 form 1040 regarding the short sale of a rental property. The single family home was purchased as a residence in 2002, and converted to rental property in 2006. The property was purchased for 192,000 originally and has not been improved in this time. It was refinanced one time but it was a no cost and no money out re-fi.

They have claimed $37,000 in depreciation expense during the time it has been a rental property.

During my short conversation with the Revenue Agent working on the audit, there seems to be a consensus between both parties that this is to be considered a non-recourse loan because the property was originally purchased as residence.

The property was sold as a short sale in Sept 2012 for $138,500. There were $8000 in selling costs. The note holder (GMAC) received $128,000 to satisfy the first mortgage on the property and there were no other mortgages or liens on the property. My client received a form 1099-C from GMAC for $51,000. The amount owed on the loan at the time of closing appears to be 179,000, which my client and IRS would agree. Both IRS and my client agree that the loan forgiveness amount listed on form 1099-C is not taxable debt forgiveness income because it was from a non-recourse loan.

At issue to the examination is the question of what shall be considered the Gross Sales Price to complete form 4797.

My clients position is the Gross Sales Price shall be equal to the short sale price of 138,500.
The IRS position is the Gross Sales price shall be equal to the amount due on the mortgage at the time of sale or 179,000.

The difference in income creates a $13,000 difference in bottom line income tax for my client.

For reference I cite the pub 544, page 2 definition of "Amount Recognized" on how I determined the gross sales price. I do not know how the Revenue Agent came to her conclusion.

Opinions would be greatly appreciated. Thank you very much for reading.

As a bonus question, should the selling costs from the short sale be a deductible selling expense?

The 'sale price' for non-recourse short sale is the amount of the loan (plus any money received, if any).


I'm sure that somebody will come along and give you the statutory support, but Publication 4681 is quite clear:

"Nonrecourse debt. If you owned property that was subject to a nonrecourse debt in excess of the FMV of the property, the lender's foreclosure on the property does not result in ordinary income from the cancellation of debt. The entire amount of the nonrecourse debt is treated as an amount realized on the disposition of the property."


This table makes if fairly easy to figure out the basics of recourse versus non-recourse debt.

For a refinance that occurred before 2013, if the original loan was refinanced with the same lender, then it remained nonrecourse. Refinancing the original nonrecourse debt with the same lender retains its nonrecourse status to the extent of the amount of the original debt. DeBerard Properties, Ltd. v. Lim, 20 Cal. 4th 659, 667-668 (1999); Ghirardo v. Antonioli, 14 Cal. 4th 39, 49-50 (1996). However, if it was refinanced with a different lender, then the refinance loan is recourse. Union Bank v. Wendland, 54 Cal.App.3d 393, 399-400 (1976).

As for determining the cancellation of debt (COD) income and gain or loss on the short sale, I suggest that you read my article, “Ten More Myths About the Tax Consequences of Foreclosures and Short Sales” (especially "Myth #4") available on the "Tax Articles" page of my website, www.fogelcpa.com.

And as long as you started with Pub. 544, continue reading to page 5, where there's a paragraph about non-recourse debt that says essentially the same thing that others have said.

I'm not one of those who thinks you can never trust the Pubs, but you've got to read them thoroughly and can't stop at the first paragraph that appears to answer your question. I daresay the same is true for any other source.

For reference I cite the pub 544, page 2 definition of "Amount Recognized" on how I determined the gross sales price.

The entire amount of the nonrecourse debt is treated as an amount realized on the disposition of the property."

Just for the record, note that amount recognized and amount realized are not necessarily the same; but they can be.

http://www.taxalmanac.org/index.php/Dis ... course_COD

Here's a post where we batted a few things around concerning a short sale that involved a non-recourse loan. Based on Dave's citations above, I don't know if OP is dealing with a non-recourse loan, a recourse loan, or some of both.

It sounds like, however, that OP taxpayer and IRS have agreed that the loan is a pure nonrecourse loan. If OP gets a bad result this way, it's okay for OP to change his mind as to the status of the debt, if feasible, based on Dave's citations.

With that said, I see what OP is arguing. OP is arguing that a short sale is a sale, so we go by the consideration shown on the settlement statement. That, however, doesn't make a lot of sense to me (if we are in fact dealing with only a nonrecourse loan). I've always thought of a short sale involving a pure nonrecourse debt to be the "functional equivalent" of a foreclosure. I stole that "functional equivalent" phrase from the Briarpark case. (And I think that is pretty much what everyone else is saying).

Here's another post with a few tidbits, including the link at the bottom in the event we're dealing with a recourse debt and a non-recourse debt. There's also a reference to Briarpark, which I referenced above, and which has been cited many times over on TA.

http://www.taxalmanac.org/index.php/Dis ... y_with_COD

It sounds like, however, that OP taxpayer and IRS have agreed that the loan is a pure nonrecourse loan. If OP gets a bad result this way, it's okay for OP to change his mind as to the status of the debt, if feasible, based on Dave's citations.

I agree.

If the OP taxpayer and IRS have agreed that the loan was nonrecourse, then the IRS is right. The principal balance of the loan at the time of the short sale (not the selling price of the property) is the amount realized in the sale. The U.S. Supreme Court has held that when a nonrecourse debt is canceled in exchange for a transfer of the property securing the debt, the transfer is treated as a sale or exchange of the property and the amount realized from the sale is the amount of the debt, even if the amount of the debt is more than the fair market value of the property. See Commissioner v. Tufts, 461 U.S. 300 (1983). See also Treas. Reg. §1.1001-2(a)(1); 2925 Briarpark Ltd. v. Commissioner, 163 F.3d 313 (5th Cir. 1990).

Not sure if I'm making this too complicated. Facts
Principal residence was converted to a rental in 2013. 2007 they built a separate structure and rented it an S corp which the client the sole shareholder. The S Corp is a residential design build remodeling contractor which was used to build both the residence and structure.

If I consider the entire property the residential rental it is on the date of sale then the COD and gain (loss) on the sale would be computed as follows:

FMV 725000
Total Debt 855868
"Quailified Indebtedness" 361176
Depreciation taken on both house and building $30691
Cost Basis $646,700

Exclusion available under IRC @108(c)(2)(A) = 0 (361175 - 725000)
No excess COD income

COD Income = 130,867 (855868 - 725000)

Gain on Sale = 108,991 (646,700-30,691) - 725000

Am I missing something on this? Do I need to separate the former commercial rental from the rest of the property?

Otherwise, I believe total taxable income resulting from the short sale would be $239,859

Since they are not qualified to use IRC @108(c)(2)(A) could they exclude part of the $108k under 121 since they would otherwise qualify with respect to the 2 out of 5 years?

Appreciate any thoughts.