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Discussion:Bankruptcy and gain

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Bgcpa (talk|edits) said:

29 March 2007

I have a client who had 2 rental properties with associated debt(one recourse and one not), reposessed and reported on form 1099-A, but who first filed Chapter 7 bankruptcy. The 1099-A in both cases shows FMV greater than his basis in the property. After researching, Cancellation of Debt income is an issue, but not taxable by filing form 982 for the one property but it appears the gain created on forclosure is taxable, even in a chapter 7 bankruptcy. Am I understanding this correctly? And if so is it taxable to the estate created, which has no assets?

Riley2 (talk|edits) said:

29 March 2007
I think you may be confusing the gain on foreclosure with the debt cancellation income. If your client lost a property through foreclosure, the debt is treated as the sales price on Form 4797 to the extent of the fair market value of the property. Any debt in excess of the "deemed sales price" will probably be nontaxable debt cancellation income if the taxpayer's personal liability is discharged in bankruptcy . In the case of nonrecourse debt, the entire debt is treated as the sales price and there would be no COD income.

Bgcpa (talk|edits) said:

30 March 2007
Understood. The COD income created ends up being non-taxable because of the Chapter 7 bankruptcy and form 982 makes it go away. My confusion comes from the lack of clarity in the instructions in Pub 908 about the reporting of the 4797 gain (separate from the COD income). The client has not been good about keeping records on his cost basis. You would figure that he couldn't borrow $60,000 on an improvement loan for a property that cost him $15,000, but he has no backup for amounts spent. As a result, he has a computed gain of $40,000 on the 4797. The instructions for bankrupcty allude to the creation of an estate and 1041 filing; in practice I wonder how often this happens and if the gain is reported by the individual or the bankruptcy estate - or if it matters. To cut to it is there any scenario where this gain (difference between FMV of property given up and basis) is not taxable given the Chapter 7 filing - which did happen before the abandoment / foreclosure?

DesertRat (talk|edits) said:

29 January 2012
This is the exact question that I have. Client filed for bankruptcy in 2010 because of a rental condo that they couldn't rent or sell. Debt discharged in the bankruptcy. Lender finally issued a 1099-A saying they took the property back in 2011. Balance outstanding 74,812 FMV 89,262 basis at the time of discharge 62,005, non-recourse. Debt was discharged in 2010. Now, if I have understood DaveFogel correctly, the basis of that condo is reduced on 1/1/2011 (the aggregate of all bases over all liabilities after discharge is going to be roughly the basis of the condo). So, the foreclosure in 2011 means that my client has a sales price of 74,812 with a basis in the neighborhood of $0?? Please tell me I am missing some really important piece to this puzzle.

DesertRat (talk|edits) said:

29 January 2012
No, I think no basis reduction because no COD. Still, a $12,000+ gain.

Kevinh5 (talk|edits) said:

29 January 2012
I'm pretty sure that Dave has time and again told us that basis reduction occurs the first of the year FOLLOWING the election.

But I agree with your next point, the 1099-A doesn't deal with COD income at all, only the sale for the balance owed.

DesertRat (talk|edits) said:

29 January 2012
OK, so nothing special about the treatment of the gain on disposition because its a bankruptcy? I'm not finding anything, just looking before I have a conversation that the client probably won't enjoy.

DaveFogel (talk|edits) said:

29 January 2012
I invite you to read my article "Reducing Tax Attributes Due to Canceled Debt Income Exclusion" as it will probably answer your question.

This question is far too complex to answer on this board. To answer it, I would need to review the bankruptcy petition, including the schedules of assets, liabilities and exempt assets. Then, I would need to determine the total debt that was discharged in bankruptcy. Next, I would have to go through each of the tax attributes in Sec. 108(b)(2) in order to see if there are any that need to be reduced. Then, I would need to calculate the limitation on the reduction of basis per Sec. 1017(b)(2). And finally, I would have to review the client's assets after the bankruptcy discharge to determine the amount of basis reduction to apply to each.

DesertRat (talk|edits) said:

30 January 2012
Thank you for the replies.

Mr Fogel, the article you linked is one of several that I keep in a desk book for reference. I'm certain that if I'm missing the boat here, its due to my lack of experience.

Do I understand correctly that what you explain in the Background section holds true whether or not the discharge is by bankruptcy? That is, for a nonrecourse loan there is no CODI.

And the word 'exclusion' in the first sentence under the heading: Reduction of Tax Attributes, means exclusion of CODI? I had read that to mean that if there was no CODI there was no reduction of tax attributes.

I had believed that since my client's loan on the condo was nonrecourse that there was no CODI and no reduction of tax attributes.

Your explanation about getting the automatic stay lifted has been quite helpful as I have practically zero experience with bankruptcies. That evidently did not occur in this case however since the lender reports the day it reacquired the property (on the 1099-A) as nearly a year after the bankruptcy was closed.

What I'm having trouble understanding is my client's basis in that period after the close of bankruptcy. I guess I had thought that the obligation to pay is what had created the basis, and the obligation went away with the discharge. Was my client still the 'owner' of the property somehow still having the same basis even without the obligation to pay? It seems that he has received the benefit of being relieved of the entire loan balance and has exchanged a property in which his interest is the original purchase price less depreciation. In his case that will be a large (to him) gain. I was asking if the bankruptcy caused any change in the way the gain on disposition was figured (other than as any other foreclosure).

I do not yet have the bankruptcy paperwork but, according to our interview, the client said that the condo was the sole reason for the proceeding--to get rid of a condo that he couldn't sell, rent, or afford. His other loans for a car and credit card he is still paying off. So I'm asking these questions without all of the facts, but I wouldn't expect you to do all the work of calculating everything anyway. I'm just trying to get straight on some concepts.

Ckenefick (talk|edits) said:

30 January 2012
You're probably incorrect in your assumption that the condo loan was non-recourse. Why would one have to enter into a personal bankruptcy proceeding to have a debt discharged for which he was never personally liable?

DesertRat (talk|edits) said:

30 January 2012
You might be right, at this point I'm just going by box 5 of the 1099-A

DaveFogel (talk|edits) said:

30 January 2012
DesertRat, here are answers to your questions:
  • No COD income for a nonrecourse loan if title to the property is transferred. You can still have COD income for a nonrecourse loan for example, in a loan modification where the taxpayer keeps the property and the loan balance is reduced.
  • Yes, “exclusion” means exclusion of COD income.
  • The bankruptcy discharge applies only to unsecured debt. For debt that is secured by real estate, the bankruptcy discharge applies only to the portion of the debt that exceeds the fair market value of the property. See IRS Letter Ruling 8918016, discussing various sections of the Bankruptcy Code. If, as you say, your client’s condo had a FMV of $89,262, and he owed $74,812, then since the FMV exceeded the loan balance, none of the debt was discharged by the bankruptcy.

DesertRat (talk|edits) said:

30 January 2012
Client dropped off what they had on the bankruptcy this am. This is Chapter 13 and the condo is listed as Surrendered Property. Looks like I need to know more: Was there an amended unsecured claim filed and has or will the Trustee make any disbursement to this creditor. Also, can I apportion part of the legal and Trustee fees as 'expense of sale'?

DaveFogel (talk|edits) said:

30 January 2012
DesertRat, you can obtain some or all of the documents from the bankruptcy case through PACER (Public Access to Court Electronic Records). Go to the PACER website (http://www.pacer.gov) and register for a PACER account. There are probably some documents that relate to the condo.

DesertRat (talk|edits) said:

30 January 2012
Thanks!! This is uncharted territory for me (as I'm sure you can tell). I'm working with a couple of EAs here but they don't seem to be very familiar with bankruptcy either.


Wiles (talk|edits) said:

13 November 2012

** NEW POST **

Thank you, DaveFogel, for the reference to PLR 8918016.

The PLR states that the individual had discharge of indebtedness income to the extent of the mortgagee's unsecured claim, which is equal to the amount by which the mortgage exceeded the farm's FMV.

However, near the end of the PLR it states that when the lender forecloses, the individual will realize gain to the extent that the balance of the mortgage exceeds the individual's basis in the farm.

I do not understand how that last part fits in here. If the taxpayer has alread recognized COD income on the part of the debt that exceeded the FMV, then how can they recognize gain again on this portion when the lender finally gets around to foreclosing.

Wiles (talk|edits) said:

13 November 2012
Allow me to provide some example numbers:
  • Taxpayer has recourse loan secured against rental property
  • In 2009, the taxpayer files for Chapter 7 bankruptcy and the trustee discharges the personal liability on the loan and abandons the property back to the taxpayer. At this time:
  • Loan balance $650K
  • Basis $500K
  • FMV $375K at time of Chapter 7 bankruptcy
  • In 2011, the lender forecloses on the property.

The PLR states that the taxpayer has cancellation of debt income in 2009 of $275K ($650K - $375K). But the PLR also seems to state that the taxpayer will have gain on sale of $150K ($650K - $500K) in 2011.

DaveFogel (talk|edits) said:

14 November 2012
Wiles, the PLR states that the taxpayer will have gain on the foreclosure to the extent that the balance of the mortgage that was not discharged in bankruptcy exceeds basis.

The PLR indicates that the bankruptcy discharges the amount of the debt that exceeds the property's FMV, and also that it converts a recourse debt to nonrecourse.

If nonrecourse debt is canceled in exchange for transfer of the property securing the debt, the transfer is treated as a sale or exchange, and the amount realized is equal to the principal amount of the debt. Commissioner v. Tufts, 461 U.S. 300 (1983); Treas. Reg. §1.1001-2(a)(1); Example (7) at Treas. Reg. §1.1001-2(c); L&C Springs Associates et al. v. Commissioner, 188 F.3d 866 (7th Cir. 1999); Rev. Rul. 76-111, 1976-1 C.B. 214.

So, in your example, the foreclosure results in a loss equal to the remaining undischarged portion of the debt ($375k) minus basis ($500k).

Wiles (talk|edits) said:

14 November 2012
Thank you, Dave. That makes sense as to how it should work. It's just that the PLR never says that the debt above the FMV was discharged. It just said that the taxpayer was relieved of any personal liability on the debt. I read that as the entire debt was still in existence. It was just converted from recourse to nonrecourse.

In my example above, if the FMV of the property grew to $450K in 2011, would the bank be able to say that the extra $75K above the $375K belongs to them. If so, then was the debt above the $375K really discharged?

DaveFogel (talk|edits) said:

14 November 2012
Wiles, you said that the PLR never says that the debt above the FMV was discharged. Yes it did:

"In the bankruptcy proceeding, X had a secured claim against the estate to the extent of the fair market value of the farm and an unsecured claim to the extent the mortgage exceeded the fair market value of the farm. Bankruptcy Code section 506. . . . X's unsecured claim, based solely on taxpayer's personal liability, was discharged."

You also ask whether the increase in FMV of the property after the bankruptcy belongs to the bank. I would say not. [edited - below, I changed this answer to "I don't know."]

Wiles (talk|edits) said:

14 November 2012
Dave, Thank you for the clarity.

I have a case similar to this with a property going into short sale that has post-BK appreciation in that property. I am going to see what the BK attorney has to say about who gets that appreciation.

Ckenefick (talk|edits) said:

14 November 2012
http://www.nacba.org/portals/0/Documents/Amicus/ChappellBrief.pdf

Possibilities: appreciation inures to debtor (good) or appreciation inures to estate (bad, as estate could use said appreciation to pay down/off creditors).

DaveFogel (talk|edits) said:

14 November 2012
Chris, the Amicus brief discusses post-petition appreciation. We're talking about post-discharge appreciation, which couldn't possibly belong to the bankruptcy estate.

Ckenefick (talk|edits) said:

14 November 2012
I'd be interested to hear what the attorney has to say on this issue. If I'm the bank, I'm pretty pissed off with Dave's theory.

Wiles (talk|edits) said:

14 November 2012
I have sent an e-mail to the BK attorney. I am sure that this is all just theoretical. This is probably how it "should" work, but I suspect for purposes of expediency the property is just abandoned by the trustee and there is no actual discharge of the excess debt during the BK.

DaveFogel (talk|edits) said:

14 November 2012
"I suspect for purposes of expediency the property is just abandoned by the trustee and there is no actual discharge of the excess debt during the BK."

This was the main point of the PLR. In the PLR, a farm was abandoned by the trustee to the taxpayer (debtor). The IRS ruled that under the Bankruptcy Code, the excess of the debt over the FMV of the farm was discharged in bankruptcy.

Ckenefick (talk|edits) said:

14 November 2012
Courts have ruled otherwise...it gets into the whole "lien stripping" issue (Dewsnup line of cases). But, I'm not sure where this all stands. I attached the wrong thing above.

Wiles (talk|edits) said:

14 November 2012
Dave, are you saying that for tax purposes the excess debt is considered discharged, but for legal purposes it is not?

DaveFogel (talk|edits) said:

14 November 2012
Chris, Dewsnup v. Timm, 502 U.S. 410 (1992) and Nobelman v. American Savings Bank, 508 U.S. 324 (1993) dealt with the question of whether the debtor may “strip” the lien on the property from the amount of the debt down to the FMV of the property as determined by the Bankruptcy Court. I believe that the cases held that this can occur in a Chapter 13, but not a Chapter 7, bankruptcy. However, this involves the lien, not whether the portion of the loan exceeding the FMV of the property was discharged in bankruptcy, which was the issue discussed in PLR 8918016. Are you saying that the Dewsnup and Nobelman cases override the PLR for Chapter 7 bankruptcies?

Wiles, I don't know what you mean by "for legal purposes." At any rate, since I'm not a lawyer, I can only address the discharge for tax purposes.

Ckenefick (talk|edits) said:

14 November 2012
Are you saying that the Dewsnup and Nobelman cases override the PLR for Chapter 7 bankruptcies?

I'm asking the same question that Wiles is asking. Who gets the appreciation?

Wiles (talk|edits) said:

21 November 2012
I have received the following reply from my clients attorney.

The property was never appraised by the bankruptcy trustee. All of the debt on the mortgage was discharged through the bankruptcy. What this means is that [the taxpayer] has no personal liability whatsoever for any of the mortgage debt or the county tax assessor debt, if any. Your question regarding whether or not the debt against the property is limited to the value of the property as determined by the bankruptcy trustee is not one that makes sense to me. In a Chapter 7, whatever mortgage debt that exists against property, that debt remains against the property but the individuals have no liability to pay that debt.

This begs the following 2 questions:

1. Was there any cancellation of debt in 2009?

2. Is the entire $650K debt now considered nonrecourse in 2011? Which would result in a 2011 gain of $150K and no excludable COD income?

Ckenefick (talk|edits) said:

21 November 2012
So, bank gets the appreciation - Is that the conclusion?

DaveFogel (talk|edits) said:

21 November 2012
Wiles, what your client's attorney told you is contrary to what a bankruptcy attorney told me. He said that the debt in excess of FMV was discharged in bankruptcy, and that the debt equal to FMV survived the bankruptcy as a nonrecourse debt (at least this latter part agrees with your client's attorney).

Perhaps your client’s attorney isn’t aware of 11 U.S.C. 506(a). This section provides that where the debt is secured and where the value of the collateral is less than the amount of the debt, the debt is split into two parts — a secured debt for the value of the collateral, and an unsecured debt for the balance.

From Senate Report No. 95-989: “Subsection (a) of this section separates an undersecured creditor’s claim into two parts: He has a secured claim to the extent of the value of his collateral; and he has an unsecured claim for the balance of his claim.”

Wiles (talk|edits) said:

21 November 2012
It seems that from the debtor's standpoint the debt in excess of FMV is discharged. However, from the creditor's standpoint it is not. The debt remains. The creditor now holds an unsecured, nonrecourse debt that remains "attached" to the property.

Wiles (talk|edits) said:

21 November 2012
Dave, My interpretation of 11 U.S.C. 506(a) is such that the creditor's loan is bifurcated into secured and unsecured. And the unsecured portion of the loan now gets to stand in line with all of the other unsecured debt of the debtor for purposes of settling the assets of the bankruptcy estate. The purpose of this section is to address how the creditor's debt is handled. It is not meant to benefit the debtor in the case that the property is abandoned by the BK estate.

In my client's case, the property was abandoned by the BK estate. The entire debt remains, however, my client no longer has any personal liability.

Using the example numbers, above, for tax purposes, the taxpayer would have COD in 2009 of $275K ($650K - $375K). In 2011, he would have a loss on sale of $125K ($375K - $500K). Agree?

Ckenefick (talk|edits) said:

21 November 2012
Do we have any attribute reduction to deal with here?

DaveFogel (talk|edits) said:

21 November 2012
Wiles, I disagree with your statement, “the entire debt remains.” The unsecured portion of the debt is treated as having been discharged in bankruptcy. The fact that the bankruptcy trustee abandons the property to the debtor means only that there’s no equity in the property for the bankruptcy estate to deal with. It doesn’t mean that the property and its debt are removed from the effect of the bankruptcy discharge.

A debt does not specifically have to be discharged by the bankruptcy court. The discharge applies to all dischargeable debts at the time the discharge is granted. See Johnson v. Commissioner, T.C. Memo. 2004-37. In this case, the taxpayer filed a Chapter 7 bankruptcy petition 9/3/91 and a trustee was appointed. Assets of the bankruptcy estate included a $153,000 business debt and two parcels of real property. The business debt became worthless during the time it was held by the estate, creating a net operating loss (NOL). The debtor owed debts to Citicorp that were secured by the properties. The bankruptcy court lifted the stay allowing Citicorp to foreclose on the properties. The debtor was released from all dischargeable debts 12/18/91. Citicorp sold the properties in 1992, leaving a deficiency of $197,500. The bankruptcy case closed in 1995 without paying this deficiency because Citicorp never filed a proof of claim. Taxpayer filed returns for 1994 and 1995 claiming the net operating loss carried over from the estate. IRS disallowed the NOLs. The Tax Court ruled that the $197,500 deficiency had been discharged by the bankruptcy court, which eliminated the NOL.

However, I agree with your numbers, as I indicated in my first post on 11/14/2012.

Wiles (talk|edits) said:

21 November 2012
Chris, Perhaps. Yes, I think you are correct. If (for tax purposes) the loan is now considered to carry a balance of $375K, then we would need to reduce the basis in the property from $500K to $375K. Therefore, no gain, no loss on the foreclosure.

Dave, Thank you for the analysis. However, the bank and the attorney both agree that the $650K of debt still exists, thus it seems that for legal purposes the entire debt does remain. It also seems that for tax purposes we pretend like the amount in excess of FMV does not remain.

Ckenefick (talk|edits) said:

21 November 2012
Who gets the appreciation in Wiles' case?

The unsecured portion of the debt is treated as having been discharged in bankruptcy

I think you mean "for federal income tax purposes" and I think you mean with respect to the taxpayer's personal liability. Does this lead us to the conclusion that, in Wiles case, when bank sells the property and fully satisfies the "secured" portion of its debt, the bank also gets to keep all remaining proceeds above and beyond said secured amount - regardless of the amount of its unsecured position (but limited to secured + unsecured positions)?

Ckenefick (talk|edits) said:

21 November 2012
Wiles just chimed in...are we all in agreement that the bank does get to keep the money?

DaveFogel (talk|edits) said:

21 November 2012
Wiles, as I said above, I don't know what you mean by "for legal purposes." Do you mean for bankruptcy purposes? Wiles and Chris, as I said above, 11 U.S.C. §506(a) separates the debt into secured and unsecured parts, and the unsecured part is discharged in bankruptcy. So, "for legal purposes," isn't the unsecured portion of the debt discharged?

Chris, if the FMV of the property goes up after the bankruptcy discharge has occurred, and if the bank forecloses and re-sells the property at an amount more than the secured portion of the debt, then I don't know whether the bank is entitled to keep the proceeds above and beyond said secured amount or whether that excess belongs to the bankruptcy estate or the debtor. This is a question that requires knowledge and application of both real estate and bankruptcy law, and I'm not an attorney.

However, what's clear is that upon the bank's foreclosure, as I said above and repeatedly in other discussions, since the secured portion of the debt has been converted to nonrecourse by the bankruptcy discharge, for the debtor/owner, the foreclosure is treated as a sale or exchange, and the amount realized is equal to the principal amount of the debt, regardless of the FMV of the property, per Commissioner v. Tufts.

Wiles (talk|edits) said:

21 November 2012
Do you mean for bankruptcy purposes?

I mean for post-BK purposes. The property was abandoned by the trustee back to the debtor. The question has to do with what happens now since the property is being foreclosed on after the bankruptcy has been settled.

So, "for legal purposes," isn't the unsecured portion of the debt discharged?

It appears that the answer to this is: No. From what I can tell all that has happened is that the debtor no longer has any personal liability on this unsecured portion, but it still remains and it is still attached to the property.

DaveFogel (talk|edits) said:

21 November 2012
"It appears that the answer to this is: No."

I disagree. Your position is in direct contradiction to 11 U.S.C. §506(a) and Letter Ruling 8918016 ("X's unsecured claim, based solely on taxpayer's personal liability, was discharged.").

Wiles (talk|edits) said:

21 November 2012
11 U.S.C. §506(a) separates the debt into secured and unsecured parts, and the unsecured part is discharged in bankruptcy.

Dave, are you making a leap here? I would agree this would be true if the property had not been abandoned by the trustee.

Edit: I think the problem here is that I am thinking that the term "discharged" means "cancelled", when, instead, it means "no longer personally liable". In that case, everything you are saying is correct, Dave.

Ckenefick (talk|edits) said:

21 November 2012
All along I'm thinking the bank shouldn't lose out here. The bank gets all the money since "all the money" is less than the original loan and the original lien hasn't been stripped down.

It does follow that, since post-discharge appreciation accrues to the bank, the bank is really deemed to be the earner of this appreciaton income, not the taxpayer. As such, the taxpayer is not deemed to have made an additional loan payment to the bank, with the possible result that taxpayer's forgiveness is something less than it otherwise would be.

Sure, the bank succeeds to this appreciation for legal purposes by virtue of its security interest, but this doesn't mean the bank is applying, should apply, or otherwise be required to apply the appreciation to the balance due from the taxpayer. After all, the taxpayer has already been absolved of personal liability by the bankrupcty court. So, for income tax purposes, we recognize the bankruptcy court's discharge order...even if property is later sold and some part of the proceeds (appreciation) reduces the bank's loss on the transaction.

DaveFogel (talk|edits) said:

21 November 2012
"Dave, are you making a leap here? I would agree this would be true if the property had not been abandoned by the trustee."

I'm not making any leap. As I said above, "The fact that the bankruptcy trustee abandons the property to the debtor means only that there’s no equity in the property for the bankruptcy estate to deal with. It doesn’t mean that the property and its debt are removed from the effect of the bankruptcy discharge."

"It does follow that, since post-discharge appreciation accrues to the bank . . ."

Now who's making a leap? Please provide me with legal authority that proves that post-discharge appreciation (during the time that the debtor still owns the property, up to the time of the foreclosure) accrues to the bank.

Ckenefick (talk|edits) said:

21 November 2012
Now who's making a leap?

Ck is, of course...but just for Wiles' case. The taxation of a transaction, including COD transactions, is based on economic reality. With a non-recourse debt, makes sense that debtor can't be sued for a deficiency. So it makes sense the lender's only recourse is against the property itself. As such, we have no COD and simply a gain/loss on sale. Of course, we need to know the amount of debt that was encumbered the property at the time of the foreclosure. This is just an example.

Wiles' point about the economics is this: If the bank get the appreciation (which appears to be the situation here), we need to ask: Why does the bank get the appreciation? Is it because the bank is entitled to it because it's lien survived the bankruptcy? Or is bank entitled to appreciation because the debtor's estate is entitled to it and debtor's estate is obligated to pay it over to the bank? If the latter, this confuses the fixed calculations that have already taken place. In other words, if we've already dealt with the COD and gain/loss calculations based on a debt level of $x, hasn't this debt level changed by virtue of debtor making an obligated payment back to the bank? In other words, was 100% of that debt the bankruptcy court said was discharged, really discharged?

Wiles (talk|edits) said:

21 November 2012
Based upon my client's attorney's response, above, I am gathering that we are confusing the definition of discharged. The attorney is saying that the debt was discharged in the bankruptcy meaning that the debtor no longer has personal liability, however, the full amount of the debt continues to exist. Discharged does not mean cancelled.

For tax purposes, this seems to leave us with a floating amount of what is considered COD and what is considered sales proceeds on nonrecourse debt. This would not be bad except for the fact that in my case the COD happens 2 years prior to the foreclosure.

DaveFogel (talk|edits) said:

22 November 2012
Chris, perhaps I missed it, but I didn't see any legal authority in your reply to support your assertion that post-discharge appreciation accrues to the bank.

"Discharged does not mean cancelled."

Say what?

Ckenefick (talk|edits) said:

22 November 2012
I fully understand your question. The lien clearly survived the bankruptcy, although personal liability was discharged.

For tax purposes, this seems to leave us with a floating amount of what is considered COD and what is considered sales proceeds on nonrecourse debt.

I don't necessarily see it that way. My take is that, for "legal purposes," the security interest held by the bank legally entitles the bank to all of the sales proceeds in this case. The security interest was never avoided or stripped down from what I can tell. In fact, it very well may be that the security interest could not be avoided under the Bankruptcy Code. As such, nothing is floating in this case. The debt levels were not changed.

Now, if the appreciation portion of the proceeds belonged to the estate and said proceeds were received by the bank, then turned over to the estate, then sent back to the bank, our debt levels would change. This would only happen if the security interest was avoided or stripped down to some extent.

Your attorney's response let me to believe that he is not expected the estate to receive anything from the bank nor is he expected the client to personally receive anything either. And I believe it is for the reasons outlined above - no part of the lien was voided.

Ckenefick (talk|edits) said:

22 November 2012
Dave, check Section 522 of the bankrupcty code, namely 522(f). And here's a snippet from Wrenn vs. American Cast Iron Pipe Company:

The Ninth Circuit rejected the Chabots' argument. It reasoned that the plain meaning of the language of Sec. 522(f) limits its lien avoidance to the value of the exemptions provided in Sec. 522(b). Id. at 895. Furthermore, it concluded that applying the plain meaning of the statute gave any postdischarge appreciation to the lienholder, and that this result was consistent with the holding of Dewsnup. Id. The court therefore refused to avoid CNB's lien.

We don't have all the facts here. But my guess is that, based on the attorney's response, the lien was not voided or stripped down, so Bank gets everything.

By the way, Dave, if you're asserting that the estate is entitled to any part of the proceeds from the sale, the entirety of your calculations falls apart, assuming some part of the proceeds are returned to the bank. Doing so would obviously change the debt levels, which are critical to determine the COD amount and the gain/loss amounts. So we wind up with circularity.

Ckenefick (talk|edits) said:

22 November 2012
"Discharged does not mean cancelled."

Say what?

Wiles' means exactly what she wrote. Personal liability was discharged, but the lien/security interest was not cancelled.

DaveFogel (talk|edits) said:

22 November 2012
Chris, you have changed the subject into an entirely different issue. I'm talking about the DEBT, and you're referring to the LIEN. I understand that a LIEN survives the Chapter 7 bankruptcy and is not removed.

When you cite a case, please provide the full cite. There appear to be several cases with the same name, so it took me awhile to find this case. In any event, Wrenn v. American Cast Iron Pipe Company, 40 F.3d 1162 (11th Cir. 1994) involved a judgment lien and its effect on the homestead exemption. It didn't involve the issue presented in this discussion. In Wiles' case, we don't know if a judgment lien was obtained by the lender.

Ckenefick (talk|edits) said:

22 November 2012
Chris, you have changed the subject into an entirely different issue.

I didn't change anything. I'm following up on the question Wiles was asking. Security interest, statutory lien, judicial lien...whatever. My take is that it wasn't avoided in Wiles case.

It didn't involve the issue presented in this discussion.

Maybe you should read it a little more carefully. It was the same issue.

What you're proposing produces a ridilicious result: Bank lends guy $1m on a recourse basis. Guy buys building for $1m (100% financed). Building plummets in value to $100k. Guy files bankruptcy. Property is kicked back to debtor. Bank forecloses on the loan when FMV is now $190k. If you're suggesting that the bank doesn't get the entire $190k, and that the debtor winds up with $90k in his pocket simply because of the $100k value attached to the property by the judge, that would be ridilicious.

DaveFogel (talk|edits) said:

22 November 2012
Chris, you should read my posts a little more carefully. I made no such suggestion. I said, "I don't know whether the bank is entitled to keep the proceeds above and beyond said secured amount or whether that excess belongs to the bankruptcy estate or the debtor."

Quite frankly, I don’t see the point of this discussion. In determining the debtor/taxpayer’s income tax consequences of the bankruptcy and subsequent foreclosure, does it really matter who is entitled to the post-discharge appreciation?

In Wiles’ example, the debtor/taxpayer has COD income resulting from the 2009 bankruptcy discharge equal to the amount of the debt ($650K) minus the FMV of the property at the time of the discharge ($375K), or $275K. All of that COD income is excludable under the bankruptcy exclusion of Sec. 108(a)(1)(A).

And then in 2011, when the bank forecloses on the property, the debtor/taxpayer has a loss equal to the principal amount of the remaining undischarged debt ($275K)($375K) minus adjusted basis ($500K), or <$125K>. Whether the bankruptcy estate, the bank or the debtor/taxpayer is entitled to the post-discharge appreciation doesn’t even enter into these calculations.

Ckenefick (talk|edits) said:

22 November 2012
The point of this discussion was that Wiles was thinking that the estate might be entitled to some money back. To the extent this happened, and to the extent the estate satisfied the bank debt with these funds, then all those numbers we used in the federal tax calculations might be different.

DaveFogel (talk|edits) said:

22 November 2012
Actually, Wiles asked whether the bank was entitled to the property's post-discharge appreciation. In the event of such appreciation, Wiles questioned whether the debt was actually discharged by the bankruptcy court. Read Wiles' first post on 11/14. I've re-read all of Wiles' posts, and I don't see anything about "thinking that the estate might be entitled to some money back."

Ckenefick (talk|edits) said:

22 November 2012
Actually, Wiles asked whether the bank was entitled to the property's post-discharge appreciation.

Let me suggest - pretty obviously - (1) that Wiles asked this question because she didn't know the answer and (2) the bank's entitlement or non-entitlement must be at the benefit or burden of someone else, even though her question didn't specifically use the word "estate." In other words: Was the bank entitled to the appreciation or was the estate?

If Wiles knew the answer to this question, she wouldn't be asking it.

Wiles obviously has some COD related calculations to do and was concerned about the impact of: Who gets the appreciation...and why - as she believed the answers affect her calculations.

And I would agree with her.

DaveFogel (talk|edits) said:

22 November 2012
And I don't think that the resolution of "who gets the appreciation" has any effect on the debtor/taxpayer's income tax consequences of the bankruptcy or the foreclosure, and the IRS letter ruling and court cases support me.

Ckenefick (talk|edits) said:

22 November 2012
First, no one here is necessarily disagreeing with you. If your position is accurate 100% of the time, then we'd like to know why. I believe, in Wiles case, the reason you're right is because the bank's security interest was not avoided to any extent. As such, the appreciation belonged to the bank by virtue of its security interest, which survived bankruptcy. It's the bank's money. Bank can do with it what it wants. In other words, the bank doesn't post it against the taxpayer's loan, doesn't need to, and has no obligation to do so. Taxpayer's obligation was already discharged. This makes sense.

Second, Wiles and I are wondering if your position is accurate in 100% of the cases. For example, if the bankruptcy court actually voided the bank's security interest for any amount above and beyond the FMV, at the time such FMV was determined by the court, and the excess (above FMV) was relegated to the unsecured class, we wonder what would happen in Wiles' case. If the bank was required to return any part of the proceeds to the court, and the bank later receives some or all of these funds back, it seems that the debt number we use for the gain/loss calculation might be different than we originally thought. In other words, when you say this:

And then in 2011, when the bank forecloses on the property, the debtor/taxpayer has a loss equal to the principal amount of the remaining undischarged debt ($275K)($375K) minus adjusted basis ($500K), or <$125K>. Whether the bankruptcy estate, the bank or the debtor/taxpayer is entitled to the post-discharge appreciation doesn’t even enter into these calculations.

...is it logical that we always use $275k$375k, even though this debt amount has since been diminished? Or better yet, what if prop comes out of bankruptcy and the taxpayer makes one or more mortgage payments prior to foreclosure, thereby reducing the principal of the debt?

If the answer is as you state (i.e. we leave the $275k$375k alone), we'd like to know why.

The answer might be simple. And it might be something you've already mentioned, but there's got to be a legal reason for it.

Wiles (talk|edits) said:

23 November 2012
Allow me to bring it back. My original post on 11/13/12 was in regards to a statement in PLR 8918016 that indicated that when the lender eventually forecloses (post-BK), the individual will realize gain to the extent that the balance of the mortgage exceeds the individual's basis in the farm.

If we use the facts presented in my next post on 11/13/12, and add to it the following fact:

  • In 2011, the value of the property grows to $450K. The lender forecloses and receives the full $450K in satisfaction for the mortgage.

The questions are:

1. What is the amount of COD recognized in 2009?

2. What is the amount of gain/loss recognized in 2011?

Wiles (talk|edits) said:

23 November 2012
I believe the answers are (or at least I wish the answers to be):

1. $275K ($650K - $375K)

2. -$125K ($375K non-discharged debt - $500K basis). However, it may be possible that the taxpayer's basis in the property was reduced to $375K at the end of 2009 due to tax attribute reduction rules. Therefore, it may be possible (very likely) that there is $0 gain/loss.

The problem is that the PLR indicated that the gain calculation for Question #2 should use the balance of the mortgage as the sales price. Does that mean we use $650K or $450K or $375K? If we use anything other than $375K, then it seems that we would be double-counting income in 2009 & 2011.

DaveFogel (talk|edits) said:

23 November 2012
First, I'd like to point out that Wiles changed the $275K number in my post and in Chris's post to $375K. Although the $375K number is correct, Wiles shouldn't be making changes to other people's posts on this board because it is prohibited, or at the very least, Wiles should have included a comment that she made these changes.

Second, in answer to Chris's post, Commissioner v. Tufts 461 U.S. 300 (1983) requires us to use the principal amount of the debt at the time of the foreclosure as the amount realized, regardless of the FMV of the property. See also Treas. Reg. §1.1001-2(a)(1); Example (7) at Treas. Reg. §1.1001-2(c); L&C Springs Associates et al. v. Commissioner, 188 F.3d 866 (7th Cir. 1999); Rev. Rul. 76-111, 1976-1 C.B. 214; and 2925 Briarpark Ltd. v. Commissioner, 163 F.3d 313 (5th Cir. 1990).

Third, in answer to Wiles' post, I've already answered these questions, and the post-discharge appreciation doesn't change anything. The amount of COD income resulting from the 2009 bankruptcy discharge equal to the amount of the debt ($650K) minus the FMV of the property at the time of the discharge ($375K), or $275K, and the loss on the 2011 foreclosure is the principal amount of the remaining undischarged debt ($375K) minus adjusted basis ($500K), or <$125K>.

It's possible that the basis of the property would be reduced as a "tax attribute." See IRC §108(b)(2)(E). But there are other tax attributes that must be considered first (NOL carryovers, general business credit carryovers, minimum tax credit carryovers, capital loss carryovers, see IRC §108(b)(2)(A) through (D)), and a calculation needs to be made to determine the limitation on the reduction of basis (IRC §1017(b)(2)). If, for example, the basis of the property is reduced to zero, then there would be a gain of $375K ($375K remaining debt minus zero basis). And the gain would be treated as an ordinary gain pursuant to the recapture rule in IRC §1017(d).

"The problem is that the PLR indicated that the gain calculation for Question #2 should use the balance of the mortgage as the sales price. Does that mean we use $650K or $450K or $375K?"

I answered this above. The key phrase in the PLR is "the balance of X's mortgage," emphasis on "balance."

Wiles (talk|edits) said:

23 November 2012
If, for example, the basis of the property is reduced to zero, then there would be a gain of $375K ($375K remaining debt minus zero basis).

This would not be possible since there is debt against the property. We cannot reduce the basis below the debt.

...emphasis on "balance."

I suppose balance would mean the remainder as in the amount that was not discharged in bankruptcy. However, this does not seem to work since the taxpayer was fully discharged of all personal liability on the entire $650K. Although, I have a feeling though that a revenue agent could make an argument that the defintion of 'balance' means the lien amount of $650K or possibly the recovered amount of $450K.


Please allow the following twist...Consider the case where the property further depreciates in 2011 to $300K. The taxpayer's personal liability on the entire mortgage has been fully discharged. The bank cannot recover the additional depreciation of $75K from the taxpayer. What would be the answer to question #2 in this case? Does the taxpayer recognize another $75K of COD in 2011? (This is what I meant by a floating amount of COD.) Then would we reduce the basis again to $300K and report as a sale at $300K, thus $0 gain/loss?

Assuming that the taxpayer's other tax attributes were fully exhausted in the BK estate, then it seems to me that the answer for #2 should be $0 gain/loss in all cases where the bank recovers $500K or less. However, trying to get to this answer using the stucture of tax code seems feels like an override.

DaveFogel (talk|edits) said:

23 November 2012
"We cannot reduce the basis below the debt."

I don't know where you're getting this, because it certainly doesn't comport with the law. I recommend that you read IRC §§108 and 1017, and my article “Reducing Tax Attributes Due to Canceled Debt Income Exclusion”.

Wiles, in my opinion, you have some strange ideas about how these rules apply. I suggest that you also read the U.S. Supreme Court's opinion in Commissioner v. Tufts. The Tufts case, and the Crane case discussed therein, both explain that the FMV of the property is irrelevant.

In the event that the property decreases in value after the bankruptcy discharge, you wouldn't have any COD income because the debt is now nonrecourse, and you can't have COD income from nonrecourse debt in a foreclosure. Again, please read Commissioner v. Tufts.

I don't see how you get to zero gain or loss on the foreclosure.

Wiles (talk|edits) said:

23 November 2012
Dave, I will admit I am taking a very simplistic approach here. I am assuming that there are no other tax attributes and that this property is the only asset that remains with the taxpayer after the bankruptcy. The basis reduction rules would then limit the reduction to the excess of the basis over the debts remaining after discharge, thus we cannot reduce basis below debt.


In regards to the Tufts case and nonrecourse debt. I will play IRS advocate here and ask, how much debt remains on the property in 2011? And I will answer $650K. The facts above show that the bank still has a lien of $650K. Then I will ask how much of this is nonrecourse? And I will answer all of it, since none of it is recourse. Therefore, if we apply Tufts, then wouldn't we have to report this as a sale at $650K? I am envisioning a Form 1099-A with $650K in Box 2 and no checkmark in Box 5.


In the event that the property decreases in value after the bankruptcy discharge...

You are correct. Your answer makes sense. Thank you.

DaveFogel (talk|edits) said:

23 November 2012
"I am assuming that there are no other tax attributes and that this property is the only asset that remains with the taxpayer after the bankruptcy."

That's unrealistic. I have worked many of these cases, and the taxpayers always have assets that are exempt under the Bankruptcy Code, such as cash, household goods, furnishings, clothing, vehicles, a retirement account, etc., and other assets that survive the bankruptcy.

However, using your hypothetical example --- that this property is the only asset that remains with the taxpayer after bankruptcy --- you are correct in your answer of no gain or loss. The excess of basis ($500K) over the debt remaining after the bankruptcy discharge ($375K) would be $125K, which would be the IRC §1017(b)(2) limitation on the reduction of basis of this property. Thus, basis is reduced from $500K to $375K. A foreclosure would result in no gain or loss because the remaining nonrecourse debt ($375K) equals the reduced basis ($375K).

"how much debt remains on the property in 2011?"

The amount of COD income resulting from the 2009 bankruptcy discharge is equal to the amount of the debt ($650K) minus the FMV of the property at the time of the discharge ($375K), or $275K. I don't care whether you think of this as the taxpayer not being personally liable for $275K of the debt anymore or whether $275K of the debt was "cancelled." The fact of the matter is that there's COD income of $275K, which is excludable under IRC §108(a)(1)(A).

If we agree on this, then it follows that the taxpayer owes only the remainder of the debt, or $650K minus $275K equals $375K. When you ask, "how much debt remains on the property," you are focusing on the property. I'm focusing on the taxpayer. The taxpayer owes only $375K since $275K was discharged in bankruptcy. There might be a lien on the property based on a larger amount of debt due to the fact that there can be no "lien stripping" in a Chapter 7 bankruptcy (see Chris's posts above regarding this point), but the fact remains that the taxpayer owes a $375K nonrecourse debt after the bankruptcy discharge.

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