Sec. 121 exclusion available to bankruptcy estate.
An individual debtor, Luciano Popa, had filed a Chapter 7 bankruptcy petition (a liquidation) in August 1996 and received discharge of his debts in December 1996. One of the assets the debtor scheduled was his principal residence, the estimated fair market value of which was $150,000. However, after deducting the outstanding mortgage, estimated broker's cost and dosing fees on a sale, trustee's fees and the homestead exemption, the debtor estimated that there would be only about $8,600 of equity available to be distributed to unsecured creditors. In addition, the court determined the income tax due from the estate on the sale of the home would be approximately $12,000, if the Sec. 121 exclusion was not available to the trustee. This was the result sought by the debtor; because there would be no equity in the home, the bankruptcy trustee would be forced to release it to the debtor. In addition, the IRS was also seeking this result, so that the maximum tax could be collected on the sale of the residence by the bankruptcy estate. On the other hand, the bankruptcy trustee sought to use the Sec. 121 exclusion to maximize the funds for the benefit of the unsecured creditors.
The court found no cases addressing whether a bankruptcy estate succeeds to the debtor's eligibility for the Sec. 121 exclusion as amended by the Taxpayer Relief Act of 1997. Two cases under prior law held that the bankruptcy trustee could not use the onetime exclusion for individuals over age 55: In re Mehr (Bktcy Ct. N.J. (1993)) and In re Barden (DC N.Y. (1996)). The court declined to follow these decisions, pointing out that they were based on original Sec. 121, which provided for an elective one-time exclusion from income, while current Sec. 121 permits a nonelective exclusion anytime a taxpayer qualifies. More significant than these changes, however, the court felt that the prior decisions did not give proper weight to the relevant Code provisions controlling the taxation of bankruptcy estates. The court pointed out that Mehr and Barden did not discuss Sec. 1398(f)(1) in any meaningful way and their analysis of Sec. 1398(g)(6) was not persuasive. In Mehr and Barden, little weight was given to Sec. 1398(g)(6) as a stand-alone section; in the court's opinion, it was intended to support Sec. 1398(g)(1)-(5), which allow for the carryover of specific tax attributes from a debtor to a bankruptcy estate.
In Popa, the court relied heavily on the statutory language of Sec. 1398(f)(1) and (g)(6). Under Sec. 1398(f)(1), the bankruptcy estate, with respect to property received from the debtor, "shall be treated as the debtor would be with respect to such asset." Under Sec. 1398(g)(6),"[i]n the case of an asset acquired by the estate from the debtor, the basis, holding period and character it had in the hands of the debtor," would be succeeded to and taken into account by the estate. The court gave more significance to this provision than a mere capital versus ordinary, short-term versus long-term analysis (as was the case in the previous decisions). The court pointed out that "character" was not defined under Sec. 1398, but should include all characteristics of the property relevant to the Code. The court felt that the attribute of real estate used as a principal residence in two out of the past five years would be relevant and should be a characteristic to which the estate succeeds. Therefore, the court held that the Sec. 121 exclusion should be available to the trustee of the bankruptcy estate in calculating its tax on the gain from the sale of the debtor's personal residence.
Under the court's reasoning, the question is where to draw the line regarding property characteristics received from a debtor. Would the bankruptcy estate be entitled to claim a rented-party suspended loss under Sec. 267 associated with the prior acquisition of the property by the debtor? Could a trustee's sale of property previously acquired in a related-party installment sale trigger the deferred gain to the original related seller? What about a related party like-kind exchange? Although Popa seems to reach an equitable result within the relevant statutory language, decisions such as this, in which the court stretches the statutory language to meet an objective, will almost certainly result in collateral litigation.
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|Title Annotation:||IRC s. 121|
|Publication:||The Tax Adviser|
|Date:||Aug 1, 1998|
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