COD, Foreclosure, and reduced basis

[bruehaus]

If a principle residence is lost in a foreclosure, and COD income is excluded as qualified principle residence exclusion, must the basis be reduced when figuring the gain/loss on foreclosure/disposition? Pub 4681 indicates that since the taxpayer no longer has the home after the foreclosure no reduction in basis is necessary. We also spoke with several IRS specialists who agree.

However, IRC 108(h)(1) states basis must be reduced if taxpayer excludes COD income using the qualified home interest exclusion. TTB has a worksheet on page 14-12 which calculates reduced basis after a foreclosure. We are confused—must you reduce basis or not?

[solomon]

I believe §108(h)(4) clarifies §108(h)(1). From (h)(4):

ORDERING RULE- If any loan is discharged, in whole or in part, and only a portion of such loan is qualified principal residence indebtedness, subsection (a)(1)(E) shall apply only to so much of the amount discharged as exceeds the amount of the loan (as determined immediately before such discharge) which is not qualified principal residence indebtedness.

In light of the ordering rule, I agree with the IRS. More succinctly, basis would not be reduced until the first of the following year of the COD. At that point in time, there would be no ownership of the residence.

[bruehaus]

The rule whereby you wait until next year to reduce basis only applies if the property is a rental, I believe. I think the IRS is correct, but Pub 523 and Pub 4681 are conflicting. I'm just wondering what some of you "experts" think on this issue.