Thread by @nittiaj

Fantastic learning material out of the Tax Court today: ustaxcourt.gov/UstcInOp/Opini….

Here are all of the issues you get introduced to in 30 pages:
1. The concept of nonrecourse debt versus recourse debt under Section 1001 (different rules than Section 752 for partnerships) (1/X)

2. Nonrecourse debt means that if you fail to repay the lender, the only option the lender has is to seize the property and keep it or sell it at auction. The lender can't come after you personally. (2/X)

3. Recourse debt means if you don't repay your lender, not only can the lender seize the property and sell it, they can also beat down your door and collect any excess deficiency (principal of loan over sales price/FMV of property). (3/X)

4. If a lender seizes and sells property subject to nonrecourse debt, the sales price is irrelevant and you are treated as having sold the property for the full amount of the nonrecourse debt. Makes sense because you are off the hook for the full debt. See Crane v. Comr. (4/X)

5. If a lender seizes and sells property subject to recourse debt, the transaction is bifurcated: you are treated as having sold the property for its FMV, and if the lender forgives the excess debt, you have COD income. See Aizawa v. Comr. (5/X)

6. Big lesson from the case: DON'T TRUST THE LENDER'S REPORTING. In this case, house was sold in a short sale, and the loan was nonrecourse, but the lender gave two 1099s -- one for the sales price and one for COD (debt - sales price). (6/X)

7. house had been converted into a rental. Original basis was $700K, FMV at time of conversion was $600K. Sales price in short sale was $360K, but loan balance was around $580K. TPer recorded loss on rental of $240K (360K - $600K) and COD income of $220K. ($580K-$360K) (7/X)

8. TPer then excluded the COD under Section 108(a)(1)(E), a temporary provision enacted in 2006 that allows you to exclude up to $2M of COD on a principal residence.
9. But Tax Court said, "there is no COD, because this debt was NONRECOURSE." (8/X)

10. This is correct. So the sales price is the full amount of the loan, or $580K. Since the loan balance is included in sales price, there can be no COD. Another way to look at it: there can be no COD because lender never had the right to collect any excess deficiency. (9/X)

11. Final big issue. and one that Judge Homes said has NEVER been decided before: when you convert principal residence to rental, your basis in the rental is the LESSER of: 1) basis or 2) FMV at the time of conversion. Basis at conversion was $700K, FMV was $600K. (10/X)

12. But under Sec. 165 regs, you only use the lower basis after conversion when computing a LOSS on the sale of the property. If the basis here was $500K (after depreciation) but the sales price (loan balance) was $580K, there WAS no loss. (11/X)

So if you have dual basis ($500K and $700K) but you sell for something in between that ($580K), what do you do? Judge Homes looked to the gift regulations, which also have a split basis when gifting property with a FMV < basis. (12/X)

Those rules say that if you sell for MORE than your loss basis but LESS than your gain basis, you recognize neither gain nor loss. So TPers didn't get their loss and the IRS didn't get their gain. No one is happy, which makes me happy, because I'm an awful human. (13/X)

End communication. (14/14)