Trustee Abandonment of Property: Effect on Pre- and Postpetition Tax Planning
| Publication year | 1992 |
| Pages | 75 |
| Citation | Vol. 21 No. 1 Pg. 75 |
1992, January, Pg. 75. Trustee Abandonment of Property: Effect on Pre- and Postpetition Tax Planning
Tax planning for an individual contemplating bankruptcy is a vital area that must be addressed if the individual is to achieve his or her "fresh start." This article focuses on the issue of abandonment of property by the trustee under § 554 of the Bankruptcy Code. This issue, although apparently a minor technical point, has a significant impact on those individuals who own property that is burdened with outstanding debt in excess of its fair market value ("FMV"). This situation is not unusual in areas where real property values are declining, such as in many Colorado cities.
Advising clients in this unenviable position requires a knowledge of the interaction of both the Internal Revenue Code of 1986, as amended(fn1) ("Code"), and bankruptcy law. As if working within the complex legal environment created by this interaction were not difficult enough, the existing tax law is far from settled in delineating the tax consequences of certain postpetition transactions (transactions that occur after a bankruptcy petition is filed and a bankruptcy estate is created).
Before exploring the more difficult questions, it is best for analytical purposes to begin by examining the tax consequences of a simple paradigm transaction. The problems explored in this article all arise from the same basic setting: an individual debtor holds property that is subject to debt in excess of the property's FMV, but the debtor's adjusted basis in the property is less than its FMV. Throughout this article, this type of property will be referred to as "Depreciated Property."
If the debtor stops paying the debt service payments on the Depreciated Property and the lender subsequently forecloses, the tax consequences to the debtor will depend on whether the debt secured by the Depreciated Property is recourse or nonrecourse debt. If the debt is recourse indebtedness, the debtor may recognize a taxable gain from the foreclosure sale in an amount equal to the difference between the amount realized from the foreclosure sale(fn2) (which is presumably equal to the property's FMV) and his or her adjusted basis. In addition, if the debtor is solvent and not involved in bankruptcy proceedings, he or she will have income from the discharge of indebtedness in an amount equal to the difference between the amount realized and the outstanding amount of the indebtedness.(fn3)
If, instead, the debt is nonrecourse, the entire outstanding amount of the debt is included in the amount realized from the sale. Thus, the debtor would have a taxable gain in an amount equal to the difference between the outstanding indebtedness and his or her adjusted basis in the Depreciated Property.(fn4)
These scenarios assume a debtor who is solvent and has not filed a bankruptcy petition. If, instead, the debtor is insolvent within the meaning of Code § 108 (d)(4), or if the liabilities secured by the Depreciated Property have been discharged in bankruptcy proceedings, Code § 108(a) will apply. Pursuant to Code § 108(a), the discharge of indebtedness income resulting from the the personal recourse scenario would not be included in the debtor's gross income.(fn5) In the case of an insolvent debtor who does not file a bankruptcy petition, the exclusion is limited to the amount by which the debtor is insolvent prior to the discharge.(fn6) To the extent that discharge of indebtedness income is excluded from the debtor's
When an individual files for bankruptcy under Chapter 7 (relating to liquidations) or Chapter 11 (relating to reorganizations) of the Bankruptcy Code, a bankruptcy estate automatically is created and is treated as a separate entity for tax purposes.(fn8) When contemplating filing a bankruptcy petition, the individual debtor holding Depreciated Property will be faced with two alternatives regarding the Depreciated Property: (1) abandon the property to the lender (or deed it to the lender if a suitable arrangement can be arrived at) before filing the petition or (2) allow the Depreciated Property to become part of the bankruptcy estate.
Where the Depreciated Property becomes part of the debtor's bankruptcy estate, any tax on the gain resulting from a subsequent sale/foreclosure is attributable to the bankruptcy estate (assuming that the estate has not abandoned the property prior to sale/foreclosure). Conversely, if the sale/foreclosure is completed before the petition is filed, the tax on the gain is a prepetition tax attributable to the debtor as an individual. This prepetition tax probably will be a nondischargeable liability.(fn9) The taxpayer generally will prefer that the Depreciated Property be in the bankruptcy estate at the time the foreclosure/sale is completed because the bankruptcy estate (rather than the individual taxpayer) is obligated to pay the tax attributable to this gain.
Whether funds of the bankruptcy estate can be used to pay the tax generated by a prepetition abandonment depends largely on whether the debtor elects to file a short-year return under Code § 1398 (d)(2). If so, the tax due for the short year will be classified as a prepetition debt that can be paid out of the estate (although the estate frequently is inadequate in amount to pay the tax, in which case the unpaid portion becomes a non-dischargable liability of the individual debtor). If the debtor does not make the Code § 1398(d)(2) election, the tax due for the year in which the petition is filed is a postpetition debt that is not payable out of the estate.(fn10)
There are two main types of postpetition abandonments.(fn11) First, property remaining in the estate at the close of the case can be abandoned to the debtor.(fn12) Second, the trustee may, after notice and a hearing, abandon property that is burdensome or of inconsequential value to the estate during its administration.(fn13) Because of the language of Code § 1398(f) (2), the effects of these two types of abandonments apparently should be quite different.
Under 11 U.S.C. § 554(c), any property of the bankruptcy estate that is not administered during the bankruptcy is deemed abandoned to the debtor at the close of the case. Further, property not consumed in the conduct of the bankruptcy (somewhat likely in a...
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