Change in Short Sale and Cancellation of Debt Income Rules?

Ouch! That's a long title! Long post too.

In the last couple of weeks California Senator Barbara Boxer received a letter response from the IRS on an inquiry made last May. The letter, from one IRS attorney, outlines what amounts to a potential change in taxation caused by a short sale of the primary residence. 

Background: When the bank forecloses on you or agrees to forgive a remaining debt through a short sale, that cancellation of debt is considered income, or CODI. (The US Code can be found at http://www.law.cornell.edu/uscode/text. Title 26 is the Internal Revenue Code, or IRC. CODI is found in IRC §61(a)(12).) A few years ago Congress added an exception to this CODI for acquisition indebtedness within certain limits for a taxpayer's primary residence (IRC §108(a)(1)(E)). Unfortunately, this is expiring.

A couple of years ago the California Legislature established a law that restricted banks that agree to a short sale from pursuing additional relief on the mortgage. Some aggressive tax practitioners asserted the position that this changed the nature of the loan to be non-recourse; there is no CODI from the forgiveness of a non-recourse loan. That is great for taxpayers, and in fact we lost a client this year because we did not take this aggressive position (which we believe is contrary to law, as identified below).

News: The recent letter from the IRS indicated that this treatment of a mortgage resolved through a short sale would cause the loan to be non-recourse and therefore there would be not CODI. This would indeed be great news!

However, maybe it is not that simple. This is only a letter from one attorney, not a memorandum from the IRS Chief Counsel. Such letters do not carry any authority and, in the past, have at times been followed by authoritative communication that contradicted the letter.

In this case the position expressed, while very much desired by taxpayers, runs contrary to various court cases. (See the 1999 case Briarpark v Commissioner for a key landmark case.) More importantly, the letter directly contradicts Treasury Regulations 1.6050P-1(b)(2)(i)(F). (Treasury Regulations, or Regs, are extensive writings generated in support of the actual law or code, often at the direction of Congress. They are authoritative in court, subordinate only to the Code and the US Constitution.) Before the IRS should take the position presented in the letter, the Regs should be updated, and that process takes time....

Certainly this letter is gaining traction in the trade media. The California Franchise Tax Board has now stated that if the IRS takes that position that they will follow.

I will not speculate where this will go, but it will be interesting to watch, and I'll undoubtedly follow-up from time to time as we have new developments. Until then, if you hear about this "new rule" or "new position the IRS is taking," I suggest you contain your enthusiasm until this is resolved.