In Year 1, our individual client (“Client”) bought a house for $400,000, borrowing $375,000 from a bank (“Bank”) on a non-recourse basis. Between Years 1 and 5, the Client and his family lived in the house. In Year 5, the 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, the 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. The 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 the 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. 

How should the Client report the short sale and mortgage cancellation on his Year 6 income tax return?