Popa Disciplines the Capital Gains Tax

Popa Disciplines the Capital Gains Tax

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s a chapter 7 panel trustee, I rarely have the chance to get excited over the many "no asset" consumer cases in which I am appointed. On rare occasions, I get an initial rush when I see that a personal residence has equity over and above the allowable homestead exemption. This euphoria soon comes to a dead stop, however, at the §341 meeting of creditors when I learn that the debtors have a very low tax basis in the residence. Liquidation of the assets for the benefit of creditors becomes unfeasible because of the capital gains tax liability that would be generated for the estate if the residence were liquidated.

Thanks to the Taxpayer Relief Act of 1997 (P.L. 105-34) and In re Luciano Popa, 1998 WL 105966 (Bankr. N.D. Ill. March 10, 1998), the thrill of liquidation and distribution to creditors has been revived.

The stage for Judge Ronald Barliant’s opinion in Popa was set by the revision of 26 U.S.C. §121 ("IRC §121"). Prior to the 1997 amendments, IRC §121 provided that taxpayers over 55 years of age were entitled to a one-time exclusion of up to $125,000 on the sale of the taxpayer’s residence ($250,000 for joint owners and joint filers) if the taxpayer had used the property as his or her principal residence for three of the last five years prior to the sale.

The Taxpayer Relief Act of 1997 amended IRC §121 to provide that an individual may exclude from income up to $250,000 of gain realized from the sale or exchange of a residence. The exclusion increases to $500,000 for joint filers. The exclusion applies to sales or exchanges after June 6, 1997 and can be claimed for only one sale every two years. The taxpayer must have owned and occupied the residence as a principal residence for an aggregate of at least two of the five years before the sale or exchange.

In Popa, the debtor filed a motion to compel the trustee to abandon the estate’s interest in the residence titled solely in the debtor’s name. The debtor alleged that after deducting the exemptions of the debtor and his non-filing spouse, no equity existed in the residence. The chapter 7 trustee objected to the motion because the non-filing spouse, who was not on the deed and had no ownership interest in the residence, was not entitled to claim the homestead exemption. The trustee also requested the court to determine, pursuant to 11 U.S.C. §505, the extent of the tax liability, if any, upon the sale of the residence. As expected, the IRS objected to the §505 request because there is no case or controversy as the house had yet to be sold.

Liquidating the residence by the trustee would arguably incur capital gains tax, which would significantly decrease the distribution to priority and unsecured creditors and diminish the liquidation efforts. To minimize the payment to the IRS and maximize the distribution to creditors, the trustee sought to invoke the relief of the Taxpayer Relief Act of 1997.

The trustee reasoned that under 26 U.S.C. §1398(g) ("IRC §1398(g)") the bankruptcy estate succeeds to the tax attributes of the debtor including the basis, holding period and character the asset had in the hand of the debtor. By succeeding to the tax attributes of the debtor, the estate was entitled to use the $250,000 exclusion because the debtor had occupied the house as a principal residence for at least two of the five years before the proposed sale, which was scheduled to occur after June 6, 1997.

In an almost unprecedented event of mutual agreement, the IRS and the debtor both argued that the IRC §121 exclusion should not apply; however, each had its own motivation for the opposition. The debtor opposed the exclusion so the trustee would not sell his residence. The IRS opposed the exclusion to ensure that the maximum taxes were paid upon the sale.

Prior to dealing with IRC §121, the court quickly dismissed the notion that the non-filing spouse, who was not on the deed, had a homestead exemption. To assert a homestead exemption under Illinois law, the non-filing spouse would have to have an ownership or leasehold interest in the property. This finding surely invigorated the trustee as the amount of equity grew by the amount of the denied exemption.

The court also rebuffed the IRS arguments that the matter was not ripe for a decision because the taxable event had not occurred, and that the court could not issue an advisory opinion on the tax issue. Judge Barliant determined that there was a "substantial controversy...between parties having adverse legal interests...of sufficient immediacy and reality to warrant the issuance of a declaratory judgment." Popa, 1998 WL 105966 at 1. See Wisconsins Environmental Decade Inc. v. State Bar of Wisconsin, 747 F.2d 407, 410 (7th Cir. 1984).

Holding that the trustee could take advantage of the IRC §121 exclusion, the court departed from two earlier decisions. The cases of In re Mehr, 153 B.R. 430 (Bankr. D.N.J. 1993) and In re Barden, 205 B.R. 451 (E.D.N.Y.1996), affd, 105 F.3d 821 (2d Cir. 1997), held that a trustee could not use the exclusion to avoid the capital gains tax upon a sale of property of the estate.

While the decisions in Mehr and Barden were made prior to the Taxpayer Relief Act of 1997, the controlling difference was in the way the courts interpreted 26 U.S.C. §1398. This section provides the guidelines for the taxation of a chapter 7 estate. IRC §1398 lists items to which the estate succeeds, such as net operating loss carryovers, recovery of tax benefits and capital loss carryovers. The Mehr and Barden courts read the list as being exhaustive, whereas the Popa court provided a more liberal and practical interpretation of the statute.

Judge Barliant followed the decision of In the Matter of Kochell, 804 F.2d 84 (7th Cir. 1986) in which the court stated that "bankruptcy should ‘mirror non-bankruptcy entitlements,’ not change the characterization of a transaction." Popa, 1998 WL 105966 at 6, citing Kochell, 804 F.2d 84, 85.

Contrary to popular belief, there actually may be some relief in the Taxpayer Relief Act of 1997. After learning of the application in Popa, I can hardly wait for my next round of "no asset" consumer cases.

Journal Date: 
Monday, June 1, 1998