Every homeowner seeks relief under the bankruptcy code, must give primary consideration to one issue: Is there any equity in the residence? The answer to this question will often determine whether the homeowner files a chapter 7 or a chapter 13 bankruptcy. However the criteria for determining whether equity exists may be changing and debtors should be especially careful in this murky area.
Prior to the enactment of the Taxpayer Relief Act of 1997, and pursuant to section 121 of the Internal Revenue Code, a homeowner aged 55 or older, was allowed a one -time exclusion of gain on the sale of a residence of up to $125,000. Prior to May 7, 1997, that exclusion was generally not available to chapter 7 bankruptcy trustees due to the fact that Internal Revenue Code section 1398(g) contained an exclusive list of tax attributes to which a bankruptcy estate succeeds and that list does not include the right to assert the section 121 exclusion.
For a residence that has been purchased in 1975 for $80,000, had no major improvements and had a current value of $150,000, the typical analysis was as follows:
Fair Market Value
of Residence $ 150,000
Less Payoff of Mortgages 102,500
Less Costs of Sale 15,000
Less Homestead Exemption 7,500
Less Capital Gain Tax 25,000
Net Equity for Trustee $ 0
There was no equity in the residence for the benefit of the estate in the above example. Since the trustee was required to pay the capital gains tax, nothing was left for the creditors, and, as a result, the trustee would simply abandon the residence back to the debtor homeowner. The homeowner could file a chapter 7 bankruptcy and, assuming he or she was current on the payments to the mortgage company, would be able to keep the residence after bankruptcy.
The enactment of the Taxpayer Relief Act of 1997, may be changing that analysis. The Act changes the capital gain exclusion and now provides that a homeowner of any age may claim $250,000 ( $500,000 for married debtors) exemption of capitol gain in the sale of his or her residence. Now, some courts, in cases decided since the enactment of the Taxpayer Relief Act, have determined that the money that used to go to pay the capital gain, can be paid by the trustee to the creditors.
The first case to address this issue was In re Popa 218 B.R. 420 (Bankr. N.D. IL 1998), appear pending. The court held that if the trustee were not allowed to take the exclusion, it would, in effect, provide debtors with a hidden exemption, outside those allowed by state or federal exemption statute to allow for a similar result. In re Munster, No. 97-51313-293 (Bankr. E.D. Mo. 1998), In re Godwin, No. 96-50782 (Bankr. S.D. Ohio 1999), appeal pending,. In re Bradley, No. 3:98-0754 (N.D. Tenn. 1999), appeal pending, and In re Kerr. No. C98-1149WD (W.D. Wash. 1999). Only a court in Ohio has ruled the other way. In re Winch, 226 B.R. 591 (Bankr. S.D. Ohio 1998).
The majority of courts have interpreted Internal Revenue Code section 1398(g)(6) to allow the bankruptcy trustee to succeed to the "character of the asset", including its use as a principal residence for at least two of the past five years. The courts have found that the use of the property as a residence for two of the past five years was an attribute in which the bankruptcy trustee could succeed, thereby triggering the section 121 exclusion under Internal Revenue Code upon the sale of the residence.
Some communicators have criticized the decisions as having misinterpreted the Internal Revenue Code. It is also not clear whether, in a case of taxpayers filing a joint chapter 7 bankruptcy, the bankruptcy estate is limited to a $250,000 exclusion.
It is anticipated that trustees will be more aggressive in selling the homes of debtors. However, this will be true only when the trustee is confident that the sale of the property will cover any taxes that might be assessed. Since the trustee is personally liable for any taxes owed, the trustee should probably file a motion with the Court for a prompt determination of any tax liability.
What are the alternatives to chapter 7? A chapter 13 bankruptcy would allow the homeowner to keep the residence and make monthly payments to creditors over time. The debtor might also be able to negotiate with the trustee. In many instances, a debtor can offer to buy the trustee’s interest in the home, often at a reduced payoff. A trustee may decide to accept a reduced amount rather than risk the uncertainties inherent in a sale of real estate.
As of now, this issue remains undecided in the eyes of debtors. Trustees and their counsel and parties are advised to err on the side of caution when determining whether to file a chapter 7 bankruptcy.
Brenda Porter Helms is a Principal of Raleigh, Helms & Finke, Wheaton. She represents creditors, debtors and trustees
in bankruptcy cases. She received her Undergraduate Degree in 1975 from the University of Wisconsin and her Law
Degree in 1982 from Loyola University. She may be reached at firstname.lastname@example.org.