On July 8, 2019, Joe and Mateo sell their principal residence for $650,000. Their adjusted basis in the property is $275,000. To complete the sale, Joe and Mateo have to take back a second mortgage for $120,000. The buyers borrow $465,000 from a local bank and put down $65,000 in cash.

In December 2021, Joe and Mateo are notified that the buyers have defaulted on the second mortgage and filed for bankruptcy. A large manufacturing plant near the house has closed, and the housing market is overstocked; the value of the house has dropped significantly -- below the amount remaining on the bank's mortgage. Joe and Mateo want to deduct the loss on the second mortgage. The IRS Hot Line adviser tells them the loss is not recognizable because there is no basis in the mortgage debt. Joe and Mateo never reported as income the payments they received on the second mortgage. Advise Joe and Mateo on the deductibility of the defaulted mortgage.