Discussion:Short Sale with Gift Tax Return filed to increase basis

From TaxAlmanac, A Free Online Resource for Tax Professionals
Note: You are using this website at your own risk, subject to our Disclaimer and Website Use and Contribution Terms.

From TaxAlmanac

Jump to: navigation, search

Discussion Forum Index --> Advanced Tax Questions --> Short Sale with Gift Tax Return filed to increase basis


Discussion Forum Index --> Tax Questions --> Short Sale with Gift Tax Return filed to increase basis

IdahoCPA (talk|edits) said:

30 March 2010
I'm pulling my hair out over this one:
  • Client purchased a house for $750K, but only paid $400K because the seller gifted their equity (and a gift return was filed to reflect the $350K gift)
  • Client turned around took a second out on the property for $300K and used the proceeds to pay off other debts.
  • Client lived there for just over a year and turned it into a rental for 10 months before short selling it for $300K.
  • Taxpayer is insolvent.

Taxpayer has two 1099-C's--one for $100K (from the first mortgage) and another for $350K (from the second mortgage).

Logically, I think the taxpayer should include $350K debt relief income (since it was used to pay of random debts). However, because he is insolvent,I fill out form 982 and lower the basis in the home to $300K (amount of debt excluded due to insolvency). The new basis now matches the sales price and there is no gain or loss and no taxable income as a result...what am I failing to see here? Thanks in advance for your response.

Dennis (talk|edits) said:

30 March 2010
Gift would probably not increase basis unless donor's basis was more than $400K. 10 months from placed in service to sale indicates basis for loss around sales price. Paid $400K and has $450K in debt after less than 2 years?

DaveFogel (talk|edits) said:

30 March 2010
If the taxpayer uses the insolvency exclusion to exclude the cancellation of debt (COD) income, then there is no reduction of the basis of the property in the year of the discharge. See IRC §§108(b)(1) and (4).

Something in your post doesn't make sense. If the taxpayer "paid $400K" upon purchase of the property and took out a $300K second mortgage, how is there $450K of debt relief? What were the amounts of the debts at the time of the short sale? What was the extent of the taxpayer's insolvency?

IdahoCPA (talk|edits) said:

30 March 2010
Sorry for not being clear... When the taxpayer purchased the home, they took out a mortgage for $400K. The purchase price on the closing statement was $750K. The difference between the loan and the purchase price was the $350K that was gifted to them in the form of equity from the seller (and a gift return was filed showing the $350K gift). After closing, the taxpayer turned around and pulled out $350K of the equity in the form of a second mortgage(my original post showed $300K--my mistake). So, $350K of the debt against the home is nonqualified/non-acquisition debt.

The taxpayer used it as a primary residence for one year and a day. They moved out and turned it into a rental for ten months and then sold it for $300K on a short sale.

The total debt at the time of short sale was $750K ($400K original loan, $350K second mortgage). The 1099-C's in front of me are $100K on the original loan and $350K from the second.

The taxpayer had other debts and was insolvent $500K at the time of the sale. I'm grateful for any advise you can offer.

IdahoCPA (talk|edits) said:

30 March 2010
BTW, my gut tells me that because the $350K was nonqualified debt, the $350K is taxable and the $100K is not. However, even if they included all the 1099-C's as income on the return, the home was a rental and would thus show a loss of $450K that would offset the gain, assuming the $750K is an accurate basis number. I have a feeling I'm mixing tax laws and am in need of some guidance on this one. I'm on little/no sleep these days.

Dennis (talk|edits) said:

30 March 2010
Any basis increase from the gift would be the excess of donor's basis over the $400K actually paid. Gift tax return is irrelevant to basis. Basis as a rental would be lower of cost or fair market value on the date placed in service.

Kevinh5 (talk|edits) said:

30 March 2010
I think the mortgage company deserved to have to write off this worthless debt. What idiots!

DaveFogel (talk|edits) said:

30 March 2010
Assuming that both debts were recourse, if recourse debt is canceled in exchange for transfer of the property securing the debt, and the balance of the debt is canceled, the transaction is split into two parts:

(1) COD income equal to the principal amount of the debt minus the FMV of the property; and
(2) Gain or loss on the disposition of the property equal to the FMV minus adjusted basis.

See Frazier v. Commissioner, 111 T.C. 243 (1998); Treas. Reg. §1.1001-2(a)(2); Example (8) at Treas. Reg. §1.1001-2(c); Rev. Rul. 90-16, 1990-1 C.B. 12.

In this case, COD income is equal to the difference between the principal amount of the debts ($400K + $350K = $750K) and the FMV of the property ($300K), or $450K.

If the taxpayer was insolvent at the time that the debt was canceled, and the extent of insolvency was $500K, then the entire $450K of COD income is excluded under the insolvency exclusion of IRC §108(a)(1)(B). Whether the debt is acquisition indebtedness or not doesn't matter for this particular exclusion.

The basis of the property is NOT reduced by the exclusion. Instead, the taxpayer's "tax attributes" such as NOLs and NOL carryovers, certain tax credits, capital loss carryovers, etc. are reduced at the beginning of the next tax year in the order listed in IRC §108(b)(2). See IRC §§108(b)(1) and (4).

The loss on the disposition cannot be determined from the information provided because, as Dennis correctly points out, the adjusted basis for determining loss depends upon the FMV of the property on the date it was converted to rental use, which is probably lower than the $750K cost. See Treas. Reg. §1.165-9(b)(2).

However, for discussion sake, assume that the FMV on the date of conversion was $400K and that $7K depreciation was deducted. Loss would then be FMV on the date of the short sale ($300K) minus adjusted basis ($400K - $7K = $393K), or $93K. This loss would be deductible as a section 1231 loss. If it creates a net operating loss, the NOL would be reduced by the COD exclusion and the taxpayer wouldn't be able to carry it to any other year.

IdahoCPA (talk|edits) said:

30 March 2010
Thank you! That answers my original question perfectly. And I agree with Kevin--what idiots! But don't get me started...

Anyway, at the risk of sounding completely inept, can someone clarify IRC §§108(b)(2)(E) that allows for property basis reduction? Does this mean any other property that the taxpayer may own? The taxpayer doesn't have any of the other section 108 attributes (or at least enough to use all the COD income). I was apparently reading this incorrectly and thought it would apply to the property sold on short sale. If they don't have any other attributes to reduce then it is my understanding that they cannot exclude the income.

DaveFogel (talk|edits) said:

31 March 2010
The basis reduction required by IRC §108(b)(2)(E) can affect the basis of a personal residence, cars, boats, household goods, retirement accounts, i.e., any asset that the taxpayer owns.

To join in on this discussion, you must first log in.
Personal tools