The Internal Revenue Service recently issued a memorandum advising of a change in its litigation position in connection with whether bankruptcy trustees must pay capital gains on the sale of homes. The change will have a major impact on how trustees assess their ability to sell a debtor's home and is a factor that must be watched carefully by bankruptcy counsel.

Every chapter 7 case is administered by a trustee who is responsible for liquidating non-exempt property of the debtor. The trustee uses the funds he raises to make payments to unsecured creditors. The vast majority of chapter 7 cases are "no-asset" cases - that is, after exemptions are taken into account, nothing is available for distribution to creditors.

When a homeowner files for Chapter 7 bankruptcy protection, he normally will protect any equity in his residence by claiming a homeowner's exemption. The amount of the exemption begins at $50,000 for single filers, increases for married couples, and increases again for senior citizens. The exemption by itself, however, is sometimes not enough to protect all the equity in the house.

Simply finding that the equity exceeds the exemption, though, does not always mean that a trustee will sell the home since the trustee must take other factors into account. The most significant of those factors has historically been the capital gain. A longtime homeowner normally has a low basis in his home. The basis is the original price paid by the homeowner. For a longtime homeowner in Southern California (where there have been huge property value increases) the capital gain

could be significant. For instance, where a home was purchased for $100,000 and is now worth $250,000 the capital gain would be $150,000 and the trustee was once responsible for paying taxes on that gain..

In addition to subtracting out the homeowner exemption and capital gains taxes, the trustee would have to factor in costs of sale, which normally are 6-7%. The capital gain payment was often enough to discourage any trustee's sale.

In the Taxpayer Relief Act of 1997, Congress eliminated the capital gains tax on most sales of residences. Despite the change in the law, however, the IRS maintained that the avoidance of the capital gains tax was personal to the debtor and could not be used by the chapter 7 trustee. Several trustees around the country tested this position and, in a series of cases, various courts decided that the Chapter 7 trustee stood in the same position as the homeowner and did not have to pay the capital gains tax. The issue has never been decided in the Ninth Circuit which is the Federal Court Circuit covering California.

Obviously, it was to the advantage of the IRS to maintain that the trustee had to pay these taxes since the payments increased the tax dollars collected by the Service. Apparently however, the IRS has now conceded that it cannot win this argument in court. The official position, which the counsel for the IRS has just adopted, is that the trustee does not have to pay residential capital gains taxes.

From this point on, when deciding whether to sell a debtor's home, the Chapter 7 trustee will have to deduct merely the exemption and the costs of sale.

Longtime homeowners will no longer benefit from the added protection which a large capital gain afforded.

September 1999.
Reprinted with permission of the The Orange County Register.