Volume 23 Issue 1 -- January/February 2011
In the last two issues, we looked at some of the basic principles of the taxation of Chapter 7 Bankruptcy proceedings. Here we will illustrate the application of those principles.
Suppose Krupke owns a home and a rental property, each subject to debt in excess of its value. He also has additional unsecured debts of $10,000. The home has a basis of $300,000, debt of $350,000, and a fair market value (FMV) of $250,000. The rental property has a basis of $850,000, debt of $1,500,000, and an FMV of $1,000,000. Krupke also has a capital loss carryover coming into 2009 of $10,000, a passive loss carryover of $50,000, and a net operating loss (NOL) carryover of $25,000.
Krupke is advised to file a Chapter 7 bankruptcy, which he does on May 1, 2009. During the course of the bankruptcy, the trustee surrenders the home and the rental property back to Krupke. Krupke obtains a discharge on August 31, 2009. In 2010, foreclosure proceedings on his home and rental property are completed.
Krupke does not elect to terminate his tax year on filing the bankruptcy. After surrendering the real properties, the trustee does not file a tax return for the Estate.
Assume that the Chapter 7 proceeding discharges all $1,860,000 of Krupke’s debt. While IRC § 108 excludes this cancellation of debt income (CODI) from income in 2009, the year of the discharge, what are the tax consequences of this bankruptcy?
Clearly Krupke must reduce his tax attributes, but when and by how much?
The tax attribute reductions are made as of the beginning of the year following the debt discharge. In Krupke’s case, this means that he will compute his 2009 tax liability before reducing tax attributes. For simplicity, it assumed none of Krupke’s tax attributes changed during 2009.
Although there is scant guidance on the question of how much reduction is required, a 1989 Private Letter Ruling (PLR) suggests the Krupke had a total of $610,000 of cancellation of debt income.
According to the PLR, the amount of CODI with respect to mortgaged real property is the excess of the amount of the debt over the property’s FMVs. The basis for this conclusion is a section of the Bankruptcy Code that effectively reduces the value of a secured claim to the value of the collateral. Krupke’s home had debt of $100,000 in excess of the FMV, while the rental property had debt of $500,000 in excess of the FMV. These amounts, combined with the $10,000 of other liabilities, equals $610,000 in CODI.
Because Krupke did not elect to reduce basis in depreciable property first, he must reduce his tax attributes in the following order: NOL, capital loss carryover, asset basis, and passive loss carryover.
Here the $610,000 in CODI eliminates the NOL ($25,000) and the capital loss carryover ($10,000). Then basis must be reduced by the remaining $575,000 of CODI. Under the ordering rules of § 1017, the basis of the rental property should be reduced before the basis in the home, meaning that all of the $575,00 of reduction is applied to the basis in the rental property, leaving it with a basis of $275,000. The basis in the home and the passive loss carryover are unaffected.
The foreclosure of each property is treated as a sale or exchange for which gain or loss must be computed. According to the PLR, after the Chapter 7 discharge, the mortgage liens on each property should be treated as nonrecourse debt. This means that on the foreclosure, Krupke is treated as realizing the total amount of the debt.
Hence on the foreclosure of the home, Krupke realizes gain equal to the $350,000 realized less the basis of $300,000, or a gain of $50,000. This gain may, perhaps, qualify for exclusion under § 121 (gain on the sale of a principal residence).
On the foreclosure of the rental property, Krupke realizes $1,5000,000 (the amount of the debt) which, less his basis of $275,000 (after the tax attribute reduction), results in a gain of $1,225,000. Because this was also a complete disposition of a passive (rental) activity, Krupke may be able to use the passive loss carryover to offset a portion of this gain.
How is the remainder of the gain taxed? IRC § 1017 says that the amount by which basis is reduced as part of a tax attribute reduction is treated as an allowed depreciation deduction. Will the gain be taxed as unrecaptured § 1250 gain at 25%? The answer is unclear, but that result appears likely.
This example illustrates a key point about the taxation of bankruptcy— the exclusion of CODI from income by § 108 operates more as a tax deferral mechanism than as a tax forgiveness device.
If you have further questions about this, please contact us.
By Tax and Business Professionals, Inc.
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