As I'm sure you felt at the time, I feel like I've stumbled upon the biggest tax "blind spot" in existence. I fully agree that the regulations are clear, you do not pay capital gains tax on "unrealized" gains, i.e., a gift of equity.
The closing company just fills out the 1099-S with the sale price, without any consideration for the gift of equity. The CPAs just want to plug in whatever number is on the 1099-S and not risk making perfectly valid adjustments. I guess I just need to find a better CPA as I doubt I will be able to convince the closing company to adjust the 1099-S.
I have a feeling the IRS is well aware of this and simply doesn't bother to clarify how it should be handled in a more direct way. I can't imagine how many people are paying the extra tax because they just don't bother to look further into it.
Thanks for the follow-up. Hope it helps someone else out there in the same situation.
