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Preparing for bankruptcy.

As the economy has slowed down, the number of real estate foreclosures and repossessions has increased. Unfortunately, the tax consequences of a foreclosure may be nearly as disastrous as the economic loss sustained by the parties. Even though bankruptcy is seen as a relief measure by taxpayer-debtors, the various ways in which excess debt is forgiven continue to be plagued with income-tax problems.

An unexpected and burdensome problem arises when a bankruptcy trustee abandons property back to a debtor, only to have a creditor foreclose on the property. This is not necessarily a problem, but the tax consequences associated with the abandonment and the resulting foreclosure may create a substantial hardship on taxpayer-debtors emerging from bankruptcy proceedings.

Real estate owners and those individuals advising real estate clients in financial distress must be aware of the tax consequences associated with abandonment transactions and the possible planning opportunities to negate an unfortunate and unexpected outcome.

Assets transfers

Generally, except when intended as a gift or bequest, income is realized by the debtor when indebtedness is forgiven or in other ways canceled. However, when a debt is discharged in bankruptcy, no income is realized. That is, no income-tax liability results from the transfer of a debtor's assets to a bankruptcy estate.

In addition, such a transfer does not trigger recapture of depreciation and investment tax credit. Likewise, the transfer of an installment obligation does not create taxable gain. The bankruptcy estate of a property owner is treated as the debtor would have been had bankruptcy not been filed.

However, such treatment may not apply if property is transferred directly to creditors outside of bankruptcy. In general, the transfer of property to creditors may result in a gain or loss and may effect the recapture of income from discharge of indebtedness.

In almost every debt workout situation, some indebtedness is discharged. The situation may be one of bankruptcy, or the lender may simply write off the debt as part of a formal or informal arrangement outside of bankruptcy. If the debtor is insolvent, the amount of debt discharged outside of bankruptcy is excluded from income only up to the amount of insolvency.

In some cases, if a creditor cannot collect the full amount of the obligation, he or she may be willing to forgive part of the debt if the debtor will sell other property and use the proceeds for a partial payment. In other cases, a partial payment coupled with a transfer of property to the creditor may be implemented.

The problem in such situations is that there is no sale to establish the disposition price or the amount of discharged debt. Therefore, a question arises with regard to how much of the forgiven obligation should be considered proceeds from disposition of property (and taxed in accordance with gain on sale of property) and how much is discharged indebtedness (which may be excludable).

Recourse debt

If the debt is recourse, the gain or loss from the "sale" of the property will be the difference between the income-tax basis of the collateral and its fair market value (FMV). To the extent that FMV falls short of the amount of debt owed, the difference is treated as discharge of indebtedness.

Transfer of property in satisfaction of a recourse note where the fair market value of the property is equal to or exceeds the debt results in no income from debt discharge. The entire obligation will be treated as proceeds from disposition of the property and subject to capital gain (or Section 1231) treatment. There has been no discharge of the debt because the lender received full FMV in satisfaction of the debt.

Example 1: Taxpayer has a recourse note of $50,000 secured by a mortgage on undeveloped land. Taxpayer transfers (currently valued at $52,000) to the financial institution in full satisfaction of the debt. Taxpayer is treated as if the land were sold for $50,000. There may be a Section 1231 gain, as well as a return of his cost basis.

However, there will be no income from discharge of indebtedness. Thus, none of the resulting income, if any, can be excluded. For instance, assume Taxpayer has a basis of $40,000 in the land. The resulting Section 1231 gain of $10,000 ($50,000-$40,000) on the transfer would not qualify for exclusion under the debt discharge rules.

When the fair market value of property transferred to a creditor in full satisfaction of a recourse obligation is less than the outstanding debt, the result is both proceeds from disposition and income from debt discharge.

The fair market value of the property and the amount of the debt determine these amounts. The fair market value of the property is considered the amount for which the property was conveyed.

Second, the debtor realizes income from discharge of indebtedness to the extent that the debt exceeds the property's fair market value. This amount may be excludable according to the rules regarding debt discharge.

Example 2: Assume that the FMV of the land in Example 1 is $42,000. By transferring the land in full satisfaction of the debt, Taxpayer is treated as having sold the land for $42,000 and then as being discharged from the debt in excess of the sales price. Taxpayer would therefore have a Section 1231 gain of $2,000 ($42,000-$40,000 basis), and discharge of indebtedness income of $8,000 ($50,000 debt-$42,000 FMV). The $8,000 may be excluded from income if Taxpayer is insolvent.

Nonrecourse debt

Nonrecourse debt, however, yields a much different outcome. In general, the fair market value of the property is ignored, and the entire difference between the income tax basis of the property and the full amount of nonrecourse-debt principal is treated as a gain or loss from the "sale" of the property.

The foreclosure or deed-in-lieu transaction is treated as a deemed sale by the borrower to the lender with proceeds equal to the amount of debt. Thus there can be no discharge of indebtedness income because the amount realized on the deemed sale equals the full amount of nonrecourse debt principal.

Example 3: Referring back to Example 2, if the note was nonrecourse, there would be no discharge of indebtedness income, but a Section 1231 gain of $10,000 ($50,000 debt-$40,000 basis).

Abandonment by the trustee

Some financially distressed taxpayers elect bankruptcy as a means of minimizing the tax burden associated with a property transfer and the discharge of debt. If a bankruptcy estate sells or disposes of property, any resulting tax liability is the responsibility of the bankruptcy estate.

The tax is paid as an administrative expense, which is a first-priority claim in the bankruptcy estate. In the event that there are insufficient assets to pay the tax, any remaining amounts do not return to the debtor.

Transferring tax liability to the bankruptcy estate, by having the estate rather than the debtor sell the property, is a significant benefit of electing a Chapter 7 bankruptcy instead of a debt-workout plan outside of bankruptcy.

However, trustees in bankruptcy may abandon property back to the debtor if the value of the property as collateral is less than the obligation. This occurs because secured creditors have first claim against the collateral, so the bankruptcy estate has nothing to gain from retaining the property. Property abandoned back to the debtor may lead to a significant tax liability if the debtor subsequently disposes of the property.

Under current tax law, it is unclear whether property abandoned to debtors returns the potential tax liability to the debtor, or whether the tax liability remains the responsibility of the bankruptcy estate. Because it is not clear which of the two positions is correct, debtors may want to resist abandonments if a significant potential income-tax liability is involved.

Two opposing theories have been identified for handling the taxation of abandoned property, based on established law. They are the "entrapment" theory, which traps the tax liability in the estate, and the "deflection" theory, which returns the liability to the debtor.


The entrapment theory has its basis in the Supreme Court cases of Crane Commissione and Tufts (In re Laymon). The entrapment theory is based on the idea that the debtor's property enters the bankruptcy estate tax-free. When later abandoned, the property passes back out of the bankruptcy estate to the debtor or the creditor. Abandonment is considered to be the critical event triggering taxable gain or loss.

If this theory is correct, the bankruptcy estate has a tax liability, and the debtor receives a stepped-up basis in the property. Upon foreclosure by a creditor, no gain is recognized by the debtor since the basis was increased to fair market value.

There is no provision making the transfer by the estate to the debtor tax-free, so general tax principles would normally trigger gain recognition on the transfer, entrapping the tax liability within the bankruptcy estate. The property would have a new income-tax basis to the debtor, the debtor would have no taxable gain if the lender repossesses the property, and the bankruptcy estate would capture any resulting income.

This theory is beneficial to the debtor; however, some court decisions are moving away from this theory.


The deflection theory has its basis in the 1937 Supreme Court case of Brown v. O'Keefe. The Court held that when property of the bankruptcy estate is abandoned, title reverts back to the debtor as of the date the petition was filed.

The deflection theory operates on the assumption that abandoned property never enters the bankruptcy estate but instead is deflected back to the debtor by the bankruptcy trustee. The language in some bankruptcy cases supports this characterization.

Under this theory, the original basis of property abandoned back to the debtor remains intact. Thus, if such property is subsequently acquired by a creditor through foreclosure, taxable income will result if the amount of the debt forgiven exceeds the FMV of the property. Further, a taxable gain will result if the property's FMV exceeds its adjusted basis.

Such income and gains on abandoned property are taxed to the debtor in the tax year when the property is acquired by the lender.

Argument for entrapment

The deflection theory creates an obvious inequity to the debtor. The differing outcomes from application of the two theories can be illustrated by the following example.

Example 4: Taxpayer (debtor) files a Chapter 7 bankruptcy owning only a piece of real estate valued at $60,000. The local bank has a security interest in the real estate for $75,000. The trustee abandons the real estate back to Taxpayer (debtor). The question is, "Who pays the tax on the $60,000?"

With the entrapment theory, the bankruptcy estate has $60,000 of income on abandonment. With the deflection theory, Taxpayer (debtor) has $60,000 of income when the real estate (collateral) is taken over by the bank.

The debtor's tax burden under the deflection theory may be even greater in some instances, as the IRS has taken the position that because of the discharge of the debtor's personal liability in bankruptcy, the debt survives abandonment as a nonrecourse obligation.

The result is that FMV is completely disregarded and the full difference between the debtor's basis in the property and the amount of the debt is gain (or loss) to the debtor. In the above example, the debtor would have $75,000 of income, rather than $60,000.

This example illustrates the current problem in trying to give a debtor a "fresh start." The objective of giving a debtor the opportunity for a "fresh start" has been recognized as a cornerstone of bankruptcy law.

This purpose of the law has been emphasized again and again by the courts as being of public as well as private interest, in that it gives the honest, but unfortunate, debtor who surrenders for distribution the property which he or she owns at the time of bankruptcy a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt.

However, as the lower courts begin to apply the deflection theory, many taxpayers are denied the fresh start espoused by Congress and the Supreme Court. Thus in the absence of corrective legislation, if a debtor is to receive the intended fresh start of the Bankruptcy Act, then the election to take bankruptcy under Chapter 7 must be carefully planned.

Planning opportunities

A possible strategy that may be undertaken to avoid such harsh treatment requires an individual debtor to elect to close his or her taxable year as of the day before the commencement date of the bankruptcy. If this election is made, the debtor's taxable year is divided into two short taxable years of less than twelve months each.

When the debtor makes this short-year election, the income-tax liability for the first, short, taxable year becomes a priority claim against the bankruptcy estate, payable out of estate assets. Accordingly, any tax liability for the year is collected from the estate, depending on the availability of estate assets to meet such claims.

Example 5: An insolvent debtor transfers an asset with a tax basis of $20,000, an FMV of $40,000, and a recourse debt of $50,000 to a creditor prior to bankruptcy. The insolvent debtor has $10,000 of income from the discharge of indebtedness ($50,000-$40,000) and a taxable gain of $20,000 ($40,000-$20,000) on the disposition of the asset.

The discharge of indebtedness income would be excluded from income under Section 108(d)(3), while the gain on the transfer of the asset would be combined with other income items and filed on the short-year tax return of the debtor.

The debtor also could use available tax attributes to offset taxable income and resulting tax liability. Any tax due would become a priority claim against the bankruptcy estate, relieving the debtor of that responsibility.

The downside of a short-tax-year election is that priority tax claims are generally not dischargeable in bankruptcy. Therefore, if an estate has insufficient assets to pay such claims, the liability will remain with the taxpayer-debtor after termination of the bankruptcy proceedings. Furthermore, any tax liability generated during the second short, taxable year is also the responsibility of the taxpayer.


Financial distress can cause adverse and expensive tax consequences to an individual. Entering a Chapter 7 bankruptcy can transfer tax liability to the bankruptcy estate, but careful planning is necessary in order to maximize the tax benefits of a Chapter 7 filing.

A serious tax problem arising out of bankruptcy may take place when property is abandoned back to the taxpayer by the trustee. However, in cases litigated, the outcome often depends upon which theory, deflection or entrapment, is implemented by the court.

As evidenced in prior cases, the IRS will probably argue for the deflection theory, with the resulting tax burden on the taxpayer/debtor. As a result, even though taxpayers may go through bankruptcy with the expectation of a "fresh start," they may come out of bankruptcy with their same "stale" financial problems. Therefore, real estate owners and real estate advisers must be aware of these adverse circumstances in order to properly contemplate bankruptcy.

Daryl V. Burckel, DBA, CPA, is professor of accounting at McNeese University, Lake Charles, Louisiana.

Mike Watters, DBA, CPA, is assistant professor of accounting at New Mexico State University, Las Cruces, N.M.

Zoel W. Dauthtrey, Ph.D., CPA, is professor of accountancy at Mississippi State University.
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Author:Burckel, Daryl V.; Watters, Mike; Dauthtrey, Zoel W.
Publication:Journal of Property Management
Date:Jul 1, 1993
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