The U.S. Tax Court affirmed the decision of the IRS that a “short sale” of real estate generated taxable income to the extent of the excused unpaid mortgage (Stevens vs. Commissioner of Internal Revenue, TC Summary Opinion 2008-61). Background: Eugene Stevens and his wife bought a two-story home in need of rehabilitation. Their intent was to rehabilitate the dwelling and then either rent the property or sell it. The purchase price was $256,000 and was financed with a bank mortgage. Subsequently, the couple was unable to make the mortgage payments, and in order to avoid a foreclosure that would have affected their credit rating, they sold the property in a short sale with the approval of the lender.
A short sale in real estate occurs when the outstanding loan against a property exceeds the market value of the property and the lender agrees to accept less than it is owed to permit the property to be sold. The Stevens sold the property for $200,000 when the unpaid balance of the mortgage was in excess of that amount by approximately $75,000. The lender approved the short sale subject to the following terms and conditions: (1) the bank was to receive approximately $181,000 in satisfaction of the loan, and (2) the balance of the purchase price was to pay the real estate commissions and closing costs. As a result, $75,000 of the loan was canceled by the bank. The bank reported the amount of the cancelled debt on a Form 1099-C. This sum was not included in the Stevens income tax return for 2003.
Income
Realized
The court stated the general rule that a taxpayer must include as income
the discharge of indebtedness. The exception to this general rule (§108a)
provides that a taxpayer may exclude income from the discharge of
indebtedness only (1) if the discharge occurs in a bankruptcy case, (2) when
the taxpayer is insolvent or (3) if the indebtedness is from business real
estate debt.
The court here
said the property was held a investment property for the production of
income but said “we cannot, for lack of sufficient facts, determine whether
the exclusion for business real property indebtedness might apply.” Since
the burden was on the Stevens to establish one of the exceptions to the
general rule and they were unable to do so, the court ruled in favor of the
IRS. Thus, the Stevens must report income of $75,000 resulting from the
short sale. In
addition, the Stevens were subject to an accuracy-related penalty pursuant
to §6662(a).
Real Estate Focus is provided by Somerset’s Real Estate Team for our clients and other interested persons upon request. Since technical information is presented in generalized fashion, no final conclusion on these topics should be made without further review. For additional information on the issues discussed, please contact Michael Fritton, CPA. Whether you are a building owner, building manager, real estate developer, real estate professional or an investor, we hope to provide you with timely information so you may be proactive in making your business decisions.
This article was written by and published herein with the permission from professionals of BDO Seidman, LLP. Robert Klein, CPA, is a Tax Partner in BDO Seidman’s New Jersey office. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.
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