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Individual bankruptcy regulations provide guidance.

When an individual files for bankruptcy protection a new taxable entity is created - the bankruptcy estate (the "estate"). The estate becomes a separate taxpayer required to compute its taxable income, elect a tax year, pay any tax and file tax returns. The individual and the estate are two distinct entities for tax purposes. Sec. 1398(g)(1) through (8) provide that the estate will succeed to a specific list of the debtor's tax attributes, including: * Net operating losses. * Charitable carryovers. * Tax benefit items. * Credit carryovers. * Capital loss carryovers. * Basis, holding period and character of assets. * Method of accounting. * Other tax attributes, to the extent provided for by regulations.

Before Nov. 9, 1992 no regulations were issued to provide for carryovers of passive activity losses (Sec. 469) or losses limited by the at-risk rules (Sec. 465).

On Nov. 9, 1992, Prop. Regs. Secs. 1.1398-1 and 1.1398-2 were issued. Prop. Regs. Sec. 1.1398-1 provides that the bankruptcy estate succeeds to the debtor's unused passive activity losses and credits. Likewise, Prop. Regs. Sec. 1.1398-2 provides that the estate succeeds to any losses of an individual debtor that were limited by the at-risk rules of Sec. 465.

These regulations end a significant issue of concern for tax practitioners who advise bankrupt debtors or their creditors. Many estates have assets encumbered by debts that will result in taxable gain if the asset is turned over to a creditor or sold to third parties. Since any tax created during the administration of the estate is a priority claim (which must be paid before general creditors), the ability to carry over the passive activity losses can make the difference between a viable plan of reorganization (Chapter 11) or a complete liquidation (Chapter 7).

If, before the termination of the estate, the estate transfers a passive activity to the debtor (other than by sale or exchange), the transfer will not be treated as a disposition and the portion of the passive activity loss attributable to the activity will also return to the debtor (Prop. Regs. Sec. 1.1398-1(d)(1) and (2)). The abandonment of an asset back to a debtor prior to the termination of the case is provided for under bankruptcy law (11 U.S.C. Section 554) on notice that the property is burdensome to the estate or is inconsequential in value. If the debtor then sells the property or it is taken in foreclosure, the debtor will have the passive activity loss available to offset the gain. (This is in contrast to unused net operating losses that do not return to the debtor until termination of the estate.) This reference to abandonment not only provides guidance on the appropriate treatment of passive losses allocated to abandoned assets, but also clarifies the treatment that no gain (or loss) occurs on the abandonment from the estate to the debtor.

On the termination of the estate, the debtor succeeds to any passive activity losses, passive activity credits or at-risk losses that were not used by the estate.

The effective date of these proposed regulations is for bankruptcy cases beginning on or after Nov. 9, 1992. For cases beginning before Nov. 9, 1992, the regulations will apply only if a joint election is made both by the debtor and the estate. If the case is under Chapter 7, the election requires the written consent of the bankruptcy trustee and a copy of the consent is to be filed with both the debtor's and the estate's tax returns. If the case is under Chapter 11, the election is made by incorporating the election in the bankruptcy plan that is confirmed by the court, along with filing the pertinent portion of the plan with the tax returns of the debtor and the estate. Since there are no regulations or prior authority for cases beginning before Nov. 9, 1992, it would follow that, absent a joint election, passive losses and losses limited by the at-risk limitations would not transfer to the estate and remain with the debtor.

Although the proposed regulations provide urgently needed guidance, they still leave numerous unanswered questions. The treatment of many tax attributes of a bankrupt debtor, including investment interest carryovers, unused Sec. 179 expenses and carryover of excess depletion, still remain unaddressed. In addition, no similar rules were provided under Sec. 108 regarding reduction of attributes for cancellation of indebtedness income. This lack of symmetry leaves the door open for interesting results (i.e., passive losses that were financed by discharged debts returning to the debtor to be used at a later time to offset future income).
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Author:Rosenberg, Neil
Publication:The Tax Adviser
Date:Apr 1, 1993
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