IRS Wins Short Sale Case But Makes a “Graev” Error in a Case where the Tax Court Acknowledges the Turbo Tax Defense

In a case with some very interesting legal issues (at least “the kind of conundrum only tax lawyers love”), the IRS is denied penalties for failing to produce the signature of a supervisor. The Tax court gave an early Christmas present to a handful of taxpayers including the Estate of Michael Jackson and Warren Sapp (consolidated with other taxpayers) in the Graev III opinion.1

It is now clear that the IRS must produce evidence that a supervisor personally approved imposition of penalties.  Otherwise, the IRS will be denied penalty assessments.  The IRS certainly is now aware of the issue and making sure to obtain and prove such approval.  However, for existing tax controversies, this may be huge win for taxpayers.  In addition, Judge Holmes discusses the possibility taxpayers who use Turbo Tax may avoid penalties due to mistakes made by the software (the “Turbo Tax Defense”).

FactsSimonsen, et al. v. Comm’r, 150 T.C. 8 (2018) dealt with a short sale of property.  Karl and Christina Simonsen purchased a home in northern California in 2005 for $695,000, and subsequently made improvements to the property.  In 2010, when the house dropped in value by $200,000 and had fair market value of $495,000 (effect of the recession), they moved to southern California and converted the home to rental property.  In 2011, while the Simonsen’s still owed Wells Fargo $555,960, they engaged in a short sale whereby a buyer purchased the home for $363,000 in full satisfaction of the indebtedness.  They received two 1099’s, a 1099-S from the sales transaction reflecting the $363,000 purchase price and a 1099-C showing that the bank cancelled the remaining $219,270 of indebtedness (which included $26,310 of costs).

Ms. Simonsen, an attorney with no tax background, prepared the couple’s income tax returns.  The Court believed that she undertook good faith efforts to understand how to report the transaction based on testimony and briefs.  As a result of those efforts, Ms. Simonson reported the sale as two transactions, a sale followed by a discharge of indebtedness.  She also determined that the debt forgiveness was subject to the exclusion for discharge of debt secured by the taxpayer’s principal residence. 2   The result of this reporting, plus a difference in reported value of the property versus what was stipulated at trial, left the Simonsen’s with a $70,000 loss.  The IRS disagreed, denied the loss, and assessed accuracy related penalties of almost $14,000.

Is a Short Sale One Transaction or Two, Separate Transactions:  A handful of interesting legal issues were presented to the Court, which stated that at least one of the issues was “the kind of conundrum only tax lawyers love.”  Judge Holmes started with a very good explanation of the definitions of recourse vs. non-recourse debt, capital income vs. cancellation-of-indebtedness income, and “principal residence” vs. any other residence.  Then, the opinion proceeded to address the question of whether the short sale constituted one transaction or two, separate transactions.  With little work and in reliance on past guidance, the Court determined that short sales constitute a single transaction for income tax purposes which are aggregated to determine the tax consequences. The sale transaction was completely dependent on the willingness of the lender to forgive the remaining indebtedness.  Otherwise, the transaction would not have been completed.  Without the lender releasing its lien on the property, the sale could not occur.  As such, the short sale constitute one, single transaction rather than two, separate transactions.

Definition of Principal Residence for Cancellation of Indebtedness Exclusion: An issue the Court indicated is “a genuinely hard question” involved the definition of “principal residence” for purposes of the §108 exclusion of cancellation of indebtedness income from the sale of the taxpayers “principal residence.”  The Simonsen’s argued that the two-in-five rule of §121 applies due to the cross-reference in §108(h)(5) to §121 and, therefore, their gain is excluded.  However, §121 does not actually define “personal residence,” but merely states that to qualify for the exclusion the taxpayer must have used the property as the taxpayer’s personal residence at least two out of the most recent five years.  There is no §121 true definition other than a list of nonexhaustive factors under the regulations.  The Court skirted the issue by resolving the case on other grounds, by indicating it only is relevant if there is gain to exclude.

Calculation of Gain or LossIn calculating gain, adjusted cost basis must be considered.  The Simonsen’s paid $695,000 for the property and made improvements.  However, the §165 regulations state that when the property is converted to rental property, the analysis for determining gain or loss changes as well.  Loss is computed using the lesser of: (1) existing adjusted basis (i.e. $695,000 plus improvement); and (2) fair market value at the time of conversion ($495,000).  This rule only applies when there is a loss, not a gain.  When the sales price falls between the two, the rule is unclear. Here, the sales price was $555,960 (the purchase price plus forgiven debt). The Court noted there is no rule for determining gain or loss under the income tax rules in this situation.  Therefore, the Court turned to the rules for calculating gain or loss when a gift is made.  Under those rules, §1015, gain is determined using the higher of the two numbers; loss is determined using the lower.  If the purchase price is between the two, there is no gain or loss.  Borrowing from that analysis, the Tax Court determined there to be no gain or loss on the transaction.  The result is that the $70,000 loss claimed by the Simonsen’s was denied.

Penalties: Going back to a series of recent opinions, Chai v. Commissioner, 851 F.3d 190 (2nd Cir. 2017) followed by Graev v. Commissioner, 149 T.C. 23 (2017) and a series of subsequent opinions, the Tax Court has reinterpreted §6751(b) to require the IRS to produce evidence that a supervisor personally approved imposition of penalties.  Otherwise, the IRS has not satisfied its burden of proof and an assessment of penalties will not be affirmed.  Citing to Graev, Judge Holmes denied the IRS’ assessment of penalties due to failure to meet its burden of production.  This case is instructive that any taxpayer before the Tax Court on penalties should look for an opportunity to prevail on this issue.  While the IRS should now be aware of the Tax Court’s newfound appreciation for §6751(b), cases already pending may provide an opportunity for taxpayers to avoid penalties.

Even after denying the IRS’ assessment of penalties under §6751(b), Judge Holmes went on to discuss the “Turbo Tax Defense” as a basis for a “reasonable cause” defense to penalties.  The taxpayer’s efforts to determine the proper tax liability is the most important factor in that defense.  Here, Mrs. Simonsen gave credible testimony that she consulted Turbo Tax instructions and IRS form instructions. Based on the that analysis, Ms. Simonsen believed she was properly reporting their income (or loss).  The couple received two, separate 1099’s, thereby making it conceivable the correct treatment was as two, separate transactions.  Further, the Court struggled with some of the issues.  Therefore, Judge Holmes, even without regard to §6751(b), stated that he would deny the IRS penalties due to reasonable case on the part of the Simonsen’s.


  1. Keith Fogg, Tax Court Reverses Itself a Year After a Fully Reviewed Opinion Acknowledging a “Graev” Mistake, Procedurally Taxing (Dec. 22, 2017), Estate of Jackson v. Comm’r, No. 17152-13 (T.C. Dec. 20, 2017), See also Rajagopalan v. Comm’r, No. 21394-11 (T.C. Dec. 20, 2017), See also Graev v. Comm’r, 149 T.C. 23 (2017).
  2. See I.R.C. § 108(a)(1)(E)


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