In Uncategorized on 03/14/2018 at 16:44

The stock market version may yield cash and a gain, but the real estate version never does, only a gain with no cash. This is the story of Karl F. Simonsen and Christina M. Simonsen, 150 T. C. 8, filed 3/14/18, and it’s a tale told many times.

For those recently arrived from other planets, Judge Holmes explains in one of his footnotes.

“In a short sale of real property, ‘the borrower sells the home to a third party for an amount that falls short of the outstanding loan balance; the lender agrees to release its lien on the property to facilitate the sale; and the borrower agrees to give all the proceeds to the lender.’” 150 T. C. 8, at p. 2 footnote 1 (Citation omitted).

Karl and Chris bought their house just before the meltdown. They converted to business use (rental), but the rent couldn’t cover the debt service. They finally unloaded for a six-figure loss, and the lender gave them a 1099-C at no extra charge.

Karl and Chris claimed the loss, plus COI wiped out by now-expired Section 108(a)(1)(E). IRS says it’s all one deal, and COI is additional gain on the sale.

The caselaw and Judge Holmes agree with IRS.

“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.” 150 T. C. 8, at pp. 17-18.

Now if Karl and Chris were still liable to Wells Fargo after the short sale, then there was no cancellation of debt. But under CA law, Wells Fargo couldn’t go after Karl and Chris once they handed over all the proceeds of sale.

So Karl and Chris got discharged from the Wells Fargo debt, and that was the consideration from the short sale.

“Because the Simonsens’ home loan was nonrecourse debt, the amount realized on its sale includes the discharged debt.  They received no consideration in addition to Wells Fargo’s forgiveness cancelling that loan balance….” 150 T. C. 8, at pp. 21-22.

OK, that’s amount realized. But in a sale we need to figure basis. That’s cost plus improvements. Judge Holmes credits Karl and Chris with some, but not enough to upset his analysis. For numbers, note that Karl and Chris paid $695,000 for the house, but stiped with IRS that at conversion from residential to commercial FMV was $495,000.

As Judge Holmes would say, now pay attention. This is why we love this stuff.

“The Simonsens realized $555,960 [the balance of the Wells Fargo loan], which falls between the basis we would use to calculate a loss ($495,000) [per Reg. 1.165-9(b)(2)] and the basis we would use to calculate a gain ($695,000)[same: difference between existing basis at conversion to commercial use or FMV at that date].  In other words, the regulations tell us to use a basis in calculating a loss that would result in a gain (because $555,960 is greater than $495,000); but they also tell us to use a basis in calculating a gain that would result in a loss (because $555,960 is less than $695,000).

“This 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.  The closest analogy we can find is to what happens to bases in property that one person gives to another.  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.’  1 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.).” 150 T. C. 8, at pp. 23-24.

Talk about Reverse Judicial Backflips! This is a Double Judicio-Legislative Back Jacknife.

But it all ends up where IRS wanted it. In another footnote.

“Our holding that the Simonsens realized neither a gain nor a loss on the short sale differs from the Commissioner’s argument on brief–that the Simonsens should’ve reported a gain.  But the notice of deficiency itself disallowed the purported loss from the short sale that the Simonsens reported on their return. Because we agree that the Simonsens didn’t realize a deductible loss on the short sale, the amount of the tax understatement in the notice of deficiency stands.” 150 T. C. 8, at p. 26.

Unable to resist yet another silt-stir, Judge Holmes finds IRS blew the Boss Hoss Section 6751(b) sign-off. But there was substantial understatement.

Now for good faith. Karl and Chris got both the 1099-C from Wells Fargo for the cancelled mortgage debt, and a 1099-S (Proceeds From Real Estate Transaction) from the CA escrowee. Together they summed up the short sale. But the 1099-C made reference to the Section 121 exclusion, which Judge Holmes bypasses by means of the no-gain-or-loss gift sale mambo. The various forms and publications from IRS are still more confusing. And “Christina is not trained in tax law–she is a lawyer but had the misfortune of not taking even Intro Tax in law school.” 150 T. C. 8, at p. 5.

“We therefore find that the Simonsens’ …reporting errors were the result of an honest misunderstanding of the law that was reasonable considering their lack of tax knowledge, the complexity of the issues, and the information returns that they received.  And we are convinced, based in large part on Christina’s honest and believable testimony, that the Simonsens acted in good faith.  Even if the Commissioner had met his burden of production, we would find that the Simonsens had met their burden of proof in refuting the penalty.” 150 T.C. 8, at pp. 29-30.

Finally, “We will not penalize taxpayers for mistakes of law in a complicated subject area that lacks clear guidance, see Everson v. United States, 108 F.3d 234, 238 (9th Cir. 1997); Van Wyk v. Commissioner, 113 T.C. 440, 449 (1999), especially when their bank dangled a red herring of a Form 1099-C in front of them.” 150 T. C. 8, at p. 29.

Judge, I’m no fan of Wells Fargo (for reasons I won’t discuss here), but Wells was obligated to issue a 1099-C, and the form is IRS’, not theirs.

OK, I’m not saying that I would have gotten the right answer…assuming that Karl and Chris don’t appeal and 9 Cir doesn’t make hash of your analysis. Possibly not even my learned colleague Peter Reilly, CPA, would reach this conclusion.

But I find it incomprehensible that a person can be admitted to the practice of law in the U. S. of A. in the Third Millennium without having taken a basic course in Federal income taxation. This is the single area of the law that impacts every citizen, every resident (legal or not), and even every sojourner in this country.  In my young day on The Hill Far Above, basic income taxation was a required course.





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