I am looking at a case that deals with recourse and nonrecourse
debt.
Normally I expect to find a partnership with multiple pages of related
entities and near-impenetrable transactions leading up to the tax dispute.
This case had to do with a rental house. I decided to read through
it.
Let’s say you buy a house in northern Kentucky. You will have a
“recourse” mortgage. This means that – if you default – the mortgage company
has the right to come after you for any shortfall if sales proceeds are
insufficient to pay-off the mortgage.
This creates an interesting tax scenario in the event of foreclosure, as the tax Code sees two
separate transactions.
EXAMPLE:
The house cost $290,000
The mortgage is $270,000
The house is worth $215,000
If the loan is recourse, the tax Code first sees the foreclosure:
The house is worth $215,000
The house cost (290,000)
Loss on foreclosure ($75,000)
The Code next sees the cancellation of debt:
The mortgage is worth $270,000
The house is worth (215,000)
Cancellation of
debt $55,000
If the house is your principal residence, the loss on foreclosure
is not tax deductible. The cancellation-of-debt income is taxable, however.
But all is not lost. Here is the Code:
§ 108 Income from discharge of indebtedness.
Gross income does not include any amount which (but
for this subsection) would be includible in gross income by reason of the
discharge (in whole or in part) of indebtedness of the taxpayer if-
(ii) subject to an arrangement that is entered into and
evidenced in writing before January 1, 2018.
The Section 108(a)(1)(E) exclusion will save you from the $55,000
cancellation-of-debt income, if you got it done by or before the December 31,
2017 deadline.
Let’s change the state. Say that you bought your house in
California.
That loan is now nonrecourse. That lender cannot hound you the way
he/she could in Kentucky.
The taxation upon cancellation of a nonrecourse loan is also
different. Rather than two steps, the tax Code now sees one.
Using the same example as above, we have:
The mortgage is $270,000
The house cost (290,000)
Loss on foreclosure ($20,000)
Notice that the California calculation does not generate
cancellation-of-debt income. As before, the loss is not deductible if it is from
your principal residence.
Back to the case.
A married couple had lived in northern California and bought a
residence. They moved to southern California and converted the residence to a
rental. The housing crisis had begun, and the house was not worth what they had
paid.
Facing a loss of over $300 grand, they got Wells Fargo to agree to
a short sale. Wells Fargo then sent them a 1099-S for taking back the house and
a 1099-C for cancellation-of-debt income.
Seems to me Wells Fargo sent paperwork for a sale in Kentucky.
Remember: there can be no cancellation-of-debt income in California.
The taxpayer’s spouse prepared the return. She was an attorney,
but she had no background in tax. She spent time on TurboTax; she spent time
reading form instructions and other sources. She did her best. You know she was
reviewing that recourse versus nonrecourse thing, as well as researching the
effect of a rental. She may have researched whether the short sale had the same
result as a regular foreclosure.
COMMENT: There was enough here to use a tax professional.
They filed a return showing around $7,000 in tax.
The IRS scoffed, saying the correct tax was closer to $76,000.
There was a lot going on here tax-wise. It wasn’t just the
recourse versus nonrecourse thing; it was also resetting the “basis” in the house
when it became a rental.
There is a requirement in tax law that property convert at lower
of (adjusted) cost or fair market value when it changes use, such as changing from
a principal residence to a rental. It can create a no-man’s land where you do
not have enough for a gain, but you simultaneously have too much for a loss. It
is nonintuitive if you haven’t been exposed to the concept.
Here is the Court:
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.”
Great. She had not even taken a tax class in law school, and now
she was involved with making tax law.
Let’s fast forward. The IRS won. They next wanted penalties – about
$14,000.
The Court didn’t think penalties were appropriate.
… the tax issues they faced in preparing their return for 2011 were complex and lacked clear answers—so much so that we ourselves had to reason by analogy to the taxation of sales of gifts and consider the puzzle of a single asset with two bases to reach the conclusion we did. We will not penalize taxpayers for mistakes of law in a complicated subject area that lacks clear guidance …”
They owed about $70 grand in tax but at least they did not owe penalties.
And the case will be remembered for being a twist on the TurboTax
defense. Generally speaking, relying on tax software will not save you from penalties,
although there have been a few exceptions. This case is one of those
exceptions, although I question its usefulness as a defense. The taxpayers here
strode into the tax twilight zone, and the Court decided the case by reasoning
through analogy. How often will that fact pattern repeat, allowing one to use this
case against the imposition of future penalties?
The case for the homegamers is Simonsen v Commissioner 150 T.C.
No. 8.
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