In 2006, Mark and Jennifer Matthews purchased a house in Miami, Florida, for $795,000, paying 20% down and financing the remainder with a loan from Bank of America. The couple lived in the house until September 2012, when they moved to Southern California. Because real estate values had dropped to less than the mortgage balance by that time, the couple converted the house to rental property and used what they believed to be the property’s fair market value (FMV) of about $600,000 at the date of conversion (later stipulated to have been $395,000) to compute depreciation for 2013. In 2013, the Matthews negotiated a sale with Bank of America and a third-party buyer for $394,000. Those proceeds were used to pay closing costs of $28,520 and to pay down the taxpayers’ loan balance of $610,960. Bank of America canceled the remaining loan balance of $245,480 and transferred the house’s title to the buyer.

The taxpayers received Form 1099-S, Proceeds From Real Estate Transactions, from the title company showing proceeds of $363,000, and Form 1099-C, Cancellation of Debt, from Bank of America showing canceled debt of $245,480. On their 2013 federal income tax return that they prepared themselves, the couple reported a deductible loss of $178,600 (proceeds of $394,000 minus an adjusted basis of $572,600) and excluded the canceled debt of $245,480 from income as discharged qualified principal residence indebtedness. The taxpayers just received a deficiency notice after the IRS disallowed the loss and they are seeking your advice.

Prepare (a) a Tax Research Memorandum in good form, and (b) a client letter in good form.