Foreclosures, Bankruptcy and capital gains.

[ErsatzAnatchist]

Please forgive me if this is an inappropriate question for this forum. I am an attorney whose practice focuses primarily on bankruptcy law. I have received very contradictory advice about a tax situation that is becoming more common and wanted to check with the smartest tax professionals on the internet.

Hypothetical Scenario:

The debtor purchases land (investment property) for $100,000 getting a mortgage to pay the purchase price. The land appreciates to $200,000 value and the debtor refinances for that amount. Now he can’t afford the payments. He files a Chapter 13 bankruptcy and surrenders the property. The secured lender forecloses on the property and the high bid at the foreclosure sale is $150,000.00 The balance of the $200,000 mortgage is discharged. In a chapter 13 bankruptcy, there is no separate taxable bankruptcy estate created (unlike in a chapter 7 case).

Answer 1: there is no “income” because of IRC §108. And, there is no “sale” because a surrender in a bankruptcy does not meet the tax law definition of “sale.” Thus, no tax owed.

Answer 2: the Debtor has a capital gain of $50,000 (representing the foreclosure sale price of $150,000 less the debtor's basis of $100,000). No forgiveness of debt income due to IRC §108.

I am confident that Answer 2 is correct, but I have been told I am wrong by one noted bankruptcy lawyer, who consulted with a tax attorney. My CPA tells my I am right.

Looking for more opinions, preferable with citations in the regs/cases/whatever.

And since I once represented Ed and Elaine Brown (7+ years ago) on a non-tax matter, I think Quatloos might find me worthy of your time).

Besides, the other option is to do your regular jobs, which cannot be as interesting as my hypothetical.

Thanks!

[Famspear]

Dear ErsatzAnatchist:

Here's a very late and therefore possibly useless response, but your choice of answer #2 appears to be correct, assuming the ordinary situation where the debtor was statutorily insolvent on an overall basis (i.e., amount of all debts immediately prior to the transaction exceeded total fair market value of all assets) by at least $50,000, AND the $200,000 debt was a recourse debt (the debtor was personally liable on the debt).

Under those assumptions, Debtor/Taxpayer has capital gain income of $50,000, and another $50,000 of putative 26 USC section 61(a)(12) income from discharge of indebtedness -- but the putative 61(a)(12) amount is excluded from income from discharge of indebtedness by 26 USC section 108(a)(1)(B) - contractual discharge of an insolvent taxpayer (and not 108(a)(1)(A), relating to bankrutpcy, although of course the taxpayer does happen to be in bankruptcy).

A separate problem would be presented if the $200,000 debt was nonrecourse debt. In such case, the Debtor would unfortunately have $100,000 of capital gain, as the entire excess of the unpaid principal balance over the Debtor's basis in the land would be treated as section 61(a)(3) gain from dealings in property, and would be included in the amount realized on the "sale or other disposition" of an asset under 26 USC section 1001. See Commissioner v. Tufts, 461 U.S. 300, 103 S. Ct. 1826 (1983).

--Yours, Famspear

[Famspear]

Post-script -- Oops I misspoke when I said:

---"the entire excess of the unpaid principal balance over the Debtor's basis in the land would be treated as section 61(a)(3) gain from dealings in property, and would be included in the amount realized on the "sale or other disposition" of an asset under 26 USC section 1001."

What I should have said is:

---"the entire unpaid principal balance of $200,000 would be treated as "amount realized" under section 1001, and the $100,000 gain ($200,000 amount realized less $100,000 basis) would be treated as section 61(a)(3) gain from dealings in property - a $100,000 capital gain."

Yours, Famspear