Facts: In Year 1, our individual client (Client) bought a house for $400,000, borrowing $375,000 from a bank (Bank) on a nonrecourse basis. Between Years 1 and 5, Client and his family lived in the house. In Year 5, Client moved out and turned the house into a rental at a time when the fair market value (FMV) of the house had dropped to $325,000. In Year 6, when $320,000 was owed on the mortgage, Client sold the house in a "short sale" for $300,000.1 Client immediately paid this amount over to the bank in partial satisfaction of the mortgage. Bank forgave the remaining balance of the debt of $20,000 ($320,000 owed less the $300,000 sales price). Bank issued a Form 1099-C to Client showing cancellation of debt income of $20,000. Client believes the short sale should be reported as a loss of $100,000 from selling the rental property ($400,000 basis - $300,000 sale proceeds). Further, although Client believes that he realized $20,000 of cancellation of debt income, he should not recognize this income because it qualifies for the exclusion related to qualified principal residence debt. Issue: How should Client report the short sale and mortgage cancellation on his Year 6 income tax return? Conclusion: Analysis: