Short Sales: Basis Implications

A discharge of indebtedness under § 108(a)(1)(E) (for more info check here) will reduce the seller’s tax basis in his house (but not below zero),  and therefore may result in the seller having a greater capital gain on the sale of his property.  See IRC § 108(h)(1).  This capital gain may, however, be excluded under the § 121 rules that exclude gain from the sale of a principal residence.  No loss deduction is allowed on a short sale of a personal residence because personal property losses are only allowed for losses arising from fire, storm, casualty or theft.  The exclusion (§ 108(a)(1)(E)) is claimed by filling out a Form 982 Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) which is attached to the taxpayer’s tax return.  Any person that is considering a short sale should seek competent professional advice to determine whether or not the § 108(a)(1)(E) exclusion applies and what other basis implications and capital gain implications exist.