What if the bankruptcy trustee abandons your property back to you?
Bankruptcy and insolvency may cause debt cancellation income to be nontaxable to the debtor, but bankruptcy can cause tax problems for an individual if the court allows or orders the trustee to abandon property under 11 USC 554.
If a property is of no value, or a potential burden to the bankruptcy estate (by virtue of tax on built-in gain for example), the court may authorize or order the property’s abandonment. If the debtor subsequently voluntarily (eg. short sale) or involuntarily (trustee’s sale) transfers title to the property, a taxable gain to the debtor may occur.
Discharge of debt income is excludable under IRC Sec. 108 to the estate and to the debtor while in a bankruptcy proceeding, but gain from the sale is generally not. If a property is sold by the estate, any potential tax would generally be an administrative expense of the estate. However if the property were to be abandoned to the debtor, then the debtor assumes the cost basis of the property subject to any reductions in basis by virtue of the debt discharge. Some practitioners believe that abandonment may be made to the secured party, rather than the debtor, in which case the debtor may be insulated from the tax consequences of a future transfer. The transfer of property between a bankruptcy estate and the debtor is non-taxable under IRC Sec. 1398. This section refers to a “termination of the estate,” but most practitioners believe it would also apply to an abandonment.
Depending on the other tax attributes of the debtor, the basis of the property abandoned might not be reduced, as the ordering rules of IRC Sec. 108 require net operating losses, capital losses, and other attributes to be reduced first, unless an election is made. There is also a limit to the reduction of basis under IRC Sec. 1017, where generally the basis of assets cannot be reduced below the aggregate of the taxpayer’s liabilities immediately after discharge.
Because any deficiency relating to the debt secured by the abandoned property is discharged, all debt secured by the property now becomes non-recourse. While some practitioners believe that the tax law should be changed, the current law treats all such transfers of the abandoned property as sales with the selling price equal to the balance of the secured loans, and the cost basis to the debtor equal to his basis before the bankruptcy reduced by any required reductions due to debt forgiveness.
If the property qualifies as a primary residence for two out of the last five years, the gain upon sale, trustee’s sale, deed in lieu, may be excluded up to $500,000 for a married person under IRC Sec. 121. If the property does not qualify as a primary residence, other losses, carryover losses, or other tax attributes (although possibly reduced by debt forgiveness) may lessen the tax burden to the debtor.
In Private Letter Ruling 8918016 (no precedent), the IRS in a pre-BAPCPA 1989 ruling, stated that an underwater farm abandoned to the taxpayer in a Chapter 7 proceeding, retained the tax basis of the property in the hands of the estate reduced by adjustments for debt forgiveness. The ruling went on to state that the abandonment of the farm to the taxpayer lifted the stay on foreclosure, and that the unsecured deficiency claim was discharged, leaving the lender’s lien against the property as a nonrecourse claim. A subsequent foreclosure would cause the taxpayer to recognize gain equal to the balance of the mortgage over the basis of the property.
In Tax Court Memo Decision 2000-82, the issue was addressed as to whether an abandonment was the equivalent of granting relief from the automatic stay. The Tax Court cited conflicting decisions as to whether property was necessarily removed from the bankruptcy estate upon the lifting of the stay. At the time of the Tax Court’s decision, it deferred to the Ninth Circuit’s 1987 decision in Wilson v. Enters, Inc. (822 F.2d 859), that relief from stay as to petitioner’s residence was an abandonment whereby the property reverted to petitioner, resulting in the petitioner, not the bankruptcy estate, having to account for the tax effects of the property’s foreclosure.
Based on the possibilities above, I would suggest that if your attorney believes it likely that a property will be abandoned by the bankruptcy trustee, a tax projection be prepared estimating the tax consequences of the property’s transfer, pre-petition versus post-petition, in order to minimize the tax penalty to the debtor.