Availability of one-time gain exclusion on sale of personal residence in bankruptcy.

An individual taxpayer and the bankruptcy estate arising when an individual files for bankruptcy are considered to be separate taxable entities. This applies if a bankruptcy case involving an individual debtor is brought under Chapter 7 (relating to liquidations) or Chapter 11 (relating to reorganizations) of Title 11 of the U.S. Code; no separate taxable entity is created on commencement of a bankruptcy case under Chapter 13 (relating to adjustment of debts of an individual with regular income). The rationale for treating the individual debtor and the bankruptcy estate as separate entities is that the individual may obtain new assets or earn wages after the transfer of prebankruptcy property to the trustee and, therefore, derive income independent of that derived by the trustee from transferred assets. However, in a Chapter 13 case, the future earnings of the debtor and exempt property may be used to make payments to creditors.

In Chapter 7 and Chapter 11 cases, the bankruptcy estate succeeds to certain tax attributes of the individual debtor. Sec. 1398(g) provides that a bankruptcy estate will succeed to and take into account certain attributes, including net operating loss carryovers under Sec. 172; carryover of excess charitable contributions under Sec. 170(d)(1); any amount to which Sec. 111 (recovery of tax benefit items) applies; the carryovers of any credit and all other items with respect to such credit which, but for bankruptcy, would be required to be taken into account by the debtor; capital loss carryovers under Sec. 1212; the basis, holding period and character of the assets acquired (other than by sale or exchange) by the estate from the debtor; the method of accounting; and other tax attributes not yet promulgated in regulations.

A transfer of attributes from a debtor to an estate effectively denies the debtor use of the tax attributes to which the estate succeeds as of the start of the case. On termination of the case, the debtor reacquires attributes transferred to the estate (except for method of accounting) and acquires attributes that arose while the case was pending.

A bankruptcy court case recently addressed the transfer of a tax attribute not specifically addressed in Sec. 1398(g) - the one-time gain exclusion under Sec. 121 on the sale of a principal residence. In In re Mehr, Bankr. D. N.J., 1/28/93, the U.S. Bankruptcy Court held that a bankruptcy estate could not elect to exclude the gain on the sale of a debtor's principal residence, even though the debtor himself would have qualified for the exclusion.

In 1989, Mehr filed for bankruptcy, transferring his personal residence to the bankruptcy estate. The trustee sold the residence in 1990 for $154,000. The taxpayer was over 55 years old and had used the property as his principal residence for a continuous period of more than five years.

The trustee reported the gain on the sale on Form 2119, Sale of Your Home, and attached it to the fiduciary return. The trustee elected the $125,000 exclusion under Sec. 121 and reported zero taxable gain ($154,000 less $89,000 basis less the Sec. 121 exclusion).

The IRS disallowed the exclusion, asserting it was unavailable to the bankruptcy estate and that the Sec. 121 exclusion could be elected only by a taxpayer who met the prescribed age and occupancy requirements. Since, in this case, a bankruptcy estate was considered to be the taxpayer, the Service stated that the estate did not meet the requirements of Sec. 121.

The trustee argued that, pursuant to Rev. Rul. 85-45, the one-time exclusion under Sec. 121 should be available to the trust. In this ruling, the IRS held that a beneficiary who was treated as the owner of a trust that owned the beneficlary's residence was entitled to the Sec. 121 exclusion. The court, however, distinguished the facts in t s case. In bankruptcy, the debtor is not the only beneficiary, nor is the debtor the sole owner of the bankruptcy estate. The trustee not only acts on the debtor's behalf, but also acts for creditors and parties in interest. In this case, the trustee's sale of the property was not only for the debtor's benefit, but also for the benefit of creditors.

The trustee also argued that pursuant to Rev. Rul. 82-1 (which allowed an individual's estate to make a Sec. 121 election after his death) the Sec. 121 exclusion should be allowed. However, the court rejected the trustee's argument; although the election in the ruling was allowed, the sale of the personal residence took place, for all practical purposes, before the taxpayer's death and before the asset passed to the estate. The court found the revenue ruling was not analogous to the case in question. The property in Mehr was first transferred to the estate and then sold by the trustee; this is not the same as the sale in the revenue ruling, which was at the taxpayer's election. Furthermore, the estate was created for the benefit of the deceased taxpayer who qualified for the election before his death; in a bankruptcy case, the estate is not only created for the benefit of an individual taxpayer, but also for the creditors' benefit.

The trustee finally argued that the Sec. 121 exclusion was available to the estate under Sec. 1398. The court stated that although certain specified tax attributes pass to the bankruptcy estate, Sec. 1398 did not apply here. Absent regulations, attributes not listed in Sce. 1398(g) are not to be transferred to a bankruptcy estate; therefore, the one-time gain exclusion was a tax attribute that remained with the debtor.

As Rev. Ruls. 82-1 and 85-45 indicate, there may be certain situations in which a taxpayer other than an individual taxpayer may elect the Sec. 121 exclusion. However, it is not available to entities whose purpose is to benefit others (e.g., creditors). Additionally, although the IRS has exclusive authority to add to the Sec. 1398(g) list by issuing regulations (evidenced by recently issued proposed regulations that would allow an individual debtor's unused passive activity losses and credits to succeed to a bankruptcy estate), it is clear that the list of tax attributes to which a bankruptcy estate may succeed is meant to be exclusive.