Facts: In Year 1, our individual client ("Client") bought a house for $400,000, borrowing
$375,000 from a bank ("Bank") on a nonrecourse basis. Between Years 1 and 5, Client and his
family lived in the house. In Year 5, Client moved out and turned the house into a rental at a
time when the fair market value (FMV) of the house had dropped to $325,000.
In Year 6, when $320,000 was owed on the mortgage, Client sold the house in a "short sale" for
$300,000.1 Client immediately paid this amount over to the bank in partial satisfaction of the
mortgage. Bank forgave the remaining balance of the debt of $20,000 ($320,000 owed less the
$300,000 sales price). Bank issued a Form 1099-C to Client showing cancellation of debt income
of $20,000.
Client believes the short sale should be reported as a loss of $100,000 from selling the rental
property ($400,000 basis - $300,000 sale proceeds). Further, although Client believes that he
realized $20,000 of cancellation of debt income, he should not recognize this income because it
qualifies for the exclusion related to qualified principal residence debt.
Issue: How should Client report the short sale and mortgage cancellation on his Year 6 income
tax return?
Conclusion:
Analysis: