Advising the noncorporate debtor through foreclosure: possibilities for eliminating capital gains in Chapter 11.

• Author: Moss, Jonathan H.

Foreclosure often results in substantial tax liability when one is least able to afford it. In a depressed real estate market, it is common to own real property with a fair market value (FMV) less than the mortgages encumbering the property; or, a business acquisition may be financed and, subsequently, the debt service cannot be met. Since the computation of the amount realized from a disposition of property generally includes cancellation of debt(1) (COD), there is an incentive to just walk away from a property that will trigger COD income, but no proceeds, on a disposition.

Because of these tax consequences, the analysis of whether to walk away from a property should not focus on mere economics. Careful planning and the judicious use of bankruptcy law can alleviate much of the sting of COD income and maximize the benefits of tax attributes (e.g., suspended losses). In addition, the success of a bankruptcy reorganization can be affected by the proper timing of a disposition of property before or after the bankruptcy filing.

Filing a chapter 11 bankruptcy petition dramatically changes the tax landscape, both procedurally and substantively. Chapter 11 enables a debtor to remain in control of the estate's assets and to propose a plan of reorganization. (In contrast, chapter 7 bankruptcy involves a liquidation of an individual debtor's assets by a court-appointed trustee.) The filing of a bankruptcy petition immediately curtails Federal(2) and state tax collection efforts. Creditors will be held at bay and the debtor will gain access to valuable tools enabling escape from uneconomic leases, contractual relationships and the burdens of past bad business decisions. A business reorganization can save goodwill and jobs and insulate future profitability from creditors. Furthermore, the filing creates a new forum to adjudicate tax disputes, even after the lapse of the 90-day period to challenge assessments in Tax Court.(3)

Whether an individual can escape capital gains tax liability stemming from COD income by filing for bankruptcy has been the subject of intense debate in the case law and the subject of tax regulations(4); a complex interaction among the Code, regulations and bankruptcy case law contributes to the analysis of this issue. Capital gains taxes incurred during the administration of a bankruptcy case may provide a limited exception to the general rule that taxes incurred within three years of a bankruptcy filing are nondischargeable.(5)

Unlike income taxes incurred prior to the commencement of a bankruptcy filing, income taxes incurred by a bankruptcy estate are payable only out of estate assets and constitute an administrative expense.(6) Sec. 1398(e)(2) provides that the debtor and the estate are separate taxable entities; thus, if the bankruptcy estate is insolvent or has only assets that are exempt from distribution, the taxing entity will be unable to collect the tax from the estate or seek a deficiency judgment from the debtor.

This article considers some of the tax planning decisions to be made in contemplating a chapter 11 filing (e.g., Sec. 108 issues), examines the separate taxable estate that arises on the filing of a bankruptcy petition, contrasts the results an individual debtor (including a husband and wife) can achieve by filing under chapter 11 versus chapter 7, considers special issues posed by partnerships and analyzes the Sec. 1398 regulations.

Timing Issues and Sec. 108

The preliminary planning considerations in deciding to file for chapter 11 are Sec. 108 and managing and protecting a client's right to use tax attributes. Sec. 108 can play a significant role in excluding a portion of the capital gain that would otherwise be taxable on a foreclosure. The Supreme Court's proclamation in Crane(7) that, on foreclosure, amount realized includes COD, still creates a shock for unsuspecting taxpayers.

Under Sec. 61(a)(12), the freeing of a liability is an accession to wealth subject to tax. When capital gain property is lost in foreclosure and generates proceeds smaller than the outstanding debt, the taxpayer realizes capital gain in the amount of the debt. Since the funds were not taxed when borrowed, when the liability is subsequently forgiven, COD income arises. In the absence of Sec. 108, this gain would be taxable under Tufts.(8)

* Application of Sec. 108

Sec. 108 may permit a taxpayer who has filed for bankruptcy to exclude a portion of the capital gain realized on foreclosure, if the debt is recourse.(9) If a creditor has recourse against the debtor, the excess of the outstanding debt over the property's FMV is COD income.(10) Since most business guarantees and obligations are recourse, nonrecourse liabilities will most likely arise for individuals investing in assets through a limited partnership or under a state law providing for nonrecourse residential mortgages.

Insolvent taxpayers who have not filed for bankruptcy may also benefit from Sec. 108, as well as taxpayers whose loans have been seller financed, so that the COD is a purchase-price reduction.(11) In either case, under Sec. 108(b), the price for excluding COD income is the reduction of certain tax attributes (e.g., net operating losses (NOLs), general business credits, capital loss carryovers, basis, passive activity losses (PALs) and foreign tax credit carryovers) by the amount of income forgiven.(12) Tax attribute reductions, which, under Sec. 108(b)(3)(A), are generally one dollar for each dollar of COD income excluded, are disclosed on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (also, Sec. 1082 basis adjustment), which should be filed with the taxpayer's return for the tax year in which discharge in bankruptcy occurs. Alternatively, a taxpayer may elect under Sec. 108(b)(5) to reduce the basis of depreciable property.

The reduction of tax attributes or election to reduce basis occurs on the first day of the tax year following the year in which the COD income occurs. Reducing attributes merely postpones gain recognition to a later date (when there will be less basis or fewer attributes to offset gain). By planning to dispose of all depreciable property and to consume tax attributes before the end of the tax year, a taxpayer can transform a temporary deferral into a permanent benefit.(13)

* Using suspended losses

Sec. 108 mandatory tax attribute reduction requires that careful consideration be given to timing issues. COD income can be offset by suspended tax attributes, including NOLs and PALs, even if the taxpayer is not insolvent or undergoing bankruptcy.

A taxpayer with multiple properties and large NOLs might benefit from disposing of properties that will generate capital gain (as opposed to COD income) before filing for chapter 11.(14) If...