IRC Section 121 Gain Exclusion for Bankrupt Debtor's Principal Residence

By Bruce M. Bird

In Brief

The Courts support a Commonsense Exclusion

The tax laws that exclude the gain from selling a primary residence from capital gains tax are less than clear-cut when bankruptcy enters the picture. Most bankruptcy court decisions since the Taxpayer Relief Act of 1997 support a bankruptcy trustee applying the exclusion to a residence sold from a bankruptcy estate, and some recent cases raise questions about how the prior law denied this exclusion.

Not surprisingly, the IRS and the courts have differing interpretations of prior and current laws and their application. In the majority of cases, however, courts have sided with bankruptcy trustees, thereby wringing at least a few drops of lemonade from the lemons that generally characterize bankruptcies.

Prior to the Taxpayer Relief Act of 1997 (TRA '97), IRC section 121 provided for a one-time exclusion of gain of up to $125,000 from the sale or exchange of a principal residence by a taxpayer age 55 or older. To qualify, the old IRC section 121 required the taxpayer to make an affirmative election claiming the exclusion and to have owned and used the property as a principal residence for at least three years during the five-year period ending on the date of sale or exchange.

However, TRA '97 changed IRC section 121 substantially. Under the current law, IRC section 121 applies to property owned and used by a taxpayer for at least two years during the five-year period ending on the date of sale or exchange. TRA '97 also increased the exclusion amount to $500,000 for a married filing jointly taxpayer and to $250,000 for all other taxpayers. Taxpayers can use the exclusion more than once, and it automatically applies to a qualifying sale of a principal residence unless an affirmative election is made to waive application of its terms.

Most bankruptcy court decisions made after TRA '97 support the ability of a trustee to assert the IRC section 121 exclusion in preparing a bankruptcy estate's income tax return. Moreover, several recent bankruptcy cases cast doubt on the legal analysis used under prior law in denying a trustee's ability to assert the old IRC section 121 exclusion.

Under Pre-TRA '97 Law

In re Mehr [153 B.R. 430 (Bankr. D. N.J. 1993)] involved husband and wife debtors that filed a joint petition under Chapter 13 of the Bankruptcy Code. In preparing both the estate's original and amended fiduciary income tax returns, the bankruptcy trustee elected to take the one-time $125,000 exclusion of gain under prior law section 121. Pursuant to an audit, the IRS disallowed the section 121 exclusion. The trustee then filed a motion in bankruptcy court to determine the estate's administrative tax liability.

In reaching its decision, the Mehr court examined the old IRC section 121 in conjunction with IRC section 1398, as well as relevant revenue rulings and legislative history. To determine whether the term "taxpayer" included a bankruptcy estate within the plain meaning of IRC section 121, the court looked to the other requirements of the exclusion.

In analyzing the old IRC section 121, the Mehr court noted that only individuals can possess its requirements of age and ownership and concluded that Congress intended for an individual, not a bankrupt estate, partnership, or corporation, to be able to make the election.

The Mehr court also examined IRC section 1398(g), which sets forth the tax attributes of the debtor to which the estate succeeds. The IRC section 121 exclusion is not contained in the list of tax attributes under IRC section 1398(g)(1­8). The court concluded that IRC section 1398(g), on its face, coupled with Congress' intent in enacting it into law, mandated that the trustee be denied the IRC section 121 exclusion.

In In re Barden [205 B.R. 451 (E.D. N.Y. 1996), aff'd, 105 F.3d 821 (2d Cir. 1997)], the trustee appealed to the U.S. District Court Eastern District of New York an order from the bankruptcy court. This order had denied the trustee's motion in a Chapter 7 case to use the prior law IRC section 121 exclusion on the sale of the debtor's residence.

In its decision, the Barden court expressly relied on Mehr, holding that the old IRC section 121 exclusion applied to individual taxpayers that attain age 55, and thus did not apply to the bankruptcy estate. Moreover, the court declined to interpret IRC section 1398, in the absence of unambiguous language to that effect in the statute itself, so as to entitle the bankruptcy estate to succeed to a qualified debtor's IRC section 121 exclusion. As a result, the court upheld the bankruptcy court's denial of the trustee's motion to use the one-time capital gains tax exclusion.

Current Law: Post-TRA '97

In re Popa [218 B.R. 420 (Bankr. N.D.I1. 1998), aff'd w/o op., Case No. 1:98-CV-0271 N.D. Il., 3/31/99)] involved a debtor who, after claiming that no equity existed in his residence, filed a motion to compel the Chapter 7 bankruptcy trustee to abandon the estate's interest in his residence. In response, the trustee objected, in part, on the grounds that the debtor, in determining that no equity existed, had improperly claimed an additional homestead exemption for his nondebtor spouse. The trustee also requested a determination of the tax liability, if any, upon the sale of the property under IRC section 505.

The IRS objected to the trustee's request, arguing that the bankruptcy court lacked jurisdiction to decide the tax issue, because until the residence in question had been sold, no case or controversy existed upon which the court could base its decision. Alternatively, the IRS argued that the trustee could not exclude the gain from the sale of the principal residence under the new IRC section 121.

The Popa court, in determining whether it had jurisdiction to address the merits of the tax issue, looked at the three-part test contained in Wisconsin's Environmental Decade, Inc. v. State Bar of Wisconsin [747 F. 2d 407, (7th Cir. 1984), cert. denied, 471 U.S. 1100 (1985) 218 B.R. 420]: For an issue to be "ripe" for determination

1) there must be a substantial controversy
2) between parties having adverse legal interests and
3) of sufficient immediacy and reality to warrant the issuance of a declaratory judgment.

The Popa court held that a substantial controversy existed concerning the amount of equity in the residence. To determine the amount of equity in the residence--and whether the trustee should be compelled to abandon it--the court indicated that it needed to consider all applicable costs due upon its potential sale, which would include capital gains tax on the sale of the residence if IRC section 121 were unavailable to the trustee.

Next, the court held that the parties had adverse legal interests. In the bankruptcy proceeding at hand, the trustee's duty to maximize distributions to the creditors of the estate ran counter to both the debtor's interest in retaining the residence and the IRS's interest in ensuring that taxes be paid upon its sale. Finally, the court decided that the controversy was of sufficient immediacy to warrant the issuance of a declaratory judgment, because only by making a determination concerning the availability of IRC section 121 could it decide the ultimate issue of abandonment under IRC section 554.

After determining that the issue at hand was within its jurisdiction, the Popa court examined IRC section 121 (both prior to and after its amendment by TRA '97) and IRC section 1398. The court noted that the amendment to IRC section 121, in eliminating the requirement that the taxpayer be at least 55 years of age, effectively removed a requirement that the estate itself could not satisfy. After analyzing other differences between IRC section 121 prior to and after its 1997 amendment, the court concluded that "IRC section 121 in its current form permits taxpayers to use the exclusion any time they otherwise qualify."

To the Popa court, the conflict between its decision and that of the Mehr and Barden decisions stems from its disagreement with the other courts' analysis of IRC section 1398. The Mehr and Barden decisions interpret subsections 1398(g)(1­5) as specifying particular "items" to which the bankruptcy estate succeeds from the debtor. These items consist of a net operating loss carryover, charitable contribution carryover, recovery under the tax benefit rule, credit carryover, and capital loss carryover. The Mehr and Barden decisions treat this list as exhaustive. Because IRC section 1398 does not specifically enumerate the IRC section 121 exclusion, the two courts concluded that Congress intended to prohibit bankruptcy estates from claiming it.

The Popa court disagreed with the Mehr and Barden courts' interpretation of IRC section 1398. The court supported its own interpretation by citing the Seventh Circuit's decision in In the Matter of Kochell [804 F. 2d 84 (7th Cir. 1986)], in which the trustee distributed funds from the individual retirement account of a bankrupt debtor to his creditors. The trustee conceded that it owed income tax on the funds withdrawn from the account but disputed the IRS's assessment of the 10% penalty under IRC section 408(f)(1), which is imposed on "the individual for whose benefit such account or annuity was established." The bankruptcy trustee argued that the debtor was the individual who benefited and thus should not be held liable for the penalty. The Seventh Circuit rejected this argument and relied on IRC section 1398(f)(1) in holding that when the debtor filed for bankruptcy, the estate was thereafter "treated as the debtor." Accordingly, when the bankruptcy trustee invaded the IRA, the estate as the "debtor"--and thus as the "individual" under IRC section 408(f)--became liable for both the income tax and the 10% penalty tax.

In addition, the Popa court noted that the interpretation of IRC section 1398 in the Kochell decision comported with the underlying policies that inform statutory construction. The Seventh Circuit indicated that bankruptcy should "mirror nonbankruptcy entitlements." Moreover, the Mehr court indicated that Congress, in enacting IRC section 1398, intended to make tax considerations as neutral as possible in determining whether a taxpayer should file a bankruptcy petition.

The Popa court noted that a taxpayer with substantial unsecured debts and equity in a principal residence could sell the house and pay the debts, or face a judgment lien foreclosure sale for the benefit of judgment creditors. Under Mehr and Barden there was another alternative: The debtor could file a bankruptcy petition before unsecured creditors got judgment liens and then discharge the debts, require the trustee to abandon the house because of the tax liability without the exclusion, sell the house with no liability owed to the discharged creditors, use the exclusion, and pocket the tax-free proceeds. As a result, the Popa court concluded that its construction of IRC section 1398 was fully consistent with congressional policy as well as the statutory language of IRC section 1398 itself.

In In re Munster [226 B.R. 632 (Bankr. E.D. Mo. 1998)], the bankruptcy court sustained the trustee's objection to the confirmation of the debtor's plan in a Chapter 13 proceeding. The court held that the "best interest of creditors" test included gain on sale of the debtor's principal residence available to a Chapter 7 trustee pursuant to IRC section 121.

In In re Bradley [222 B.R. 313 (Bankr. M.D. Tn. 1998)], the debtor filed a petition under Chapter 13 of the Bankruptcy Code. Several months later, her case converted to Chapter 7. The trustee later sold the debtor's residence, resulting in a gain of approximately $77,000. On the bankruptcy estate's income tax return, the trustee declared the gain on the sale of the debtor's residence but excluded it from income under IRC section 121. After the IRS rejected the return, the trustee filed a motion for determination of tax liability pursuant to IRC section 505(b).

In making its decision, the Bradley court drew heavily on the Popa decision, noting:

Popa accurately observes that the 1997 amendments to IRC section 121 undermine the policy arguments in Mehr and Barden against the use of the exclusion by a bankruptcy trustee. More importantly, Popa's construction of IRC section 1398 is true to the plain meaning of words in that section, gives effect to all its subsections, and avoids the dead spots and lapses of logic created by the construction of Mehr and Barden.

As a result, the bankruptcy court in Bradley held that the trustee's use of the IRC section 121 exclusion on the estate's federal tax return was proper.

In re Winch [226 B.R. 591 (Bankr. S.D. Oh. 1998)] represents the sole decision to date in favor of the IRS and against the bankruptcy trustee in a case involving the estate's use of the amended IRC section 121 exclusion. The court in Winch noted that IRC section 1398 was not amended in 1997, despite the amendment to IRC section 121, and found that the Mehr and Barden decisions remain viable and persuasive. The court in Winch found it necessary to read sections 121 and 1398 together to resolve the issue, and because the language of the two statutes was not plain, found it appropriate to focus on the underlying policies of the statutes. The court in Winch concluded that the 1997 amendment to IRC section 121 did not alter the policies inherent in that IRC section and "supports a holding that it is the individual taxpayer and not the bankruptcy estate that should be eligible for the exclusion."

With In re Godwin [230 B.R. 341 (Bankr. S.D. Oh. 1999)] and In re St. Francis [83 AFTR 2d 2289 (4/2/99)], both courts found the Popa line of reasoning to be persuasive and specifically declined to follow the Winch decision. In addition, a conflict currently exists in the Bankruptcy Court for the Southern District of Ohio, with the Eastern Division--the Godwin court--finding in favor of the trustee, but the Western Division (Winch) finding in favor of the IRS.

Unanswered Questions

Current law leaves some questions unanswered concerning the trustee's use of the IRC section 121 exclusion. Section 121 is unusual in that the maximum allowable exclusion depends on the taxpayer's filing status. For a taxpayer with a married filing jointly tax status, IRC section 121 provides for a maximum exclusion of $500,000. The maximum exclusion is $250,000 for any other taxpayer.

To date, all of the decisions concerning this issue have involved a trustee seeking to claim the $250,000--rather than $500,000--maximum exclusion. As a practical matter, in most of these cases the trustee had no need to attempt to claim an exclusion amount greater than $250,000, either because the taxpayer could not file a married filing jointly return or because the amount of realized gain was less than $250,000.

St. Francis is the sole decision involving a sale with a realized gain in excess of $250,000. In this decision, the trustee sought to exclude $250,000 of the $265,309 potential capital gain from the sale of the estate's one-half interest in the residence. The debtor's spouse, who had not filed a bankruptcy petition, held the other one-half interest. It should be noted that, assuming that the filing status of the debtor's spouse was other than married filing jointly, a total of $500,000 could be excluded from the tax returns of the estate of the bankrupt debtor and of the nondebtor spouse.

To further complicate matters, it is possible for both spouses to file a joint petition in bankruptcy. As a result, whether the $250,000 or $500,000 maximum exclusion amount would apply is unclear. Given the approach in Popa, an argument can be made for using the $500,000 maximum exclusion amount, but this issue has yet to be addressed by any bankruptcy court.

Also unclear is whether IRC section 121 would apply to other situations involving fiduciaries. While an executor can use IRC section 121 to avoid income in respect to a decedent in certain situations, and while IRC section 121 can apply to property held by a grantor trust, whether the new exclusion could be used in a situation involving a qualified personal residence trust is unclear.

Agree to disagree. Both before and after TRA '97, the IRS has persistently opposed the use of the IRC section 121 exclusion by a bankruptcy trustee upon the sale of the debtor's residence. Under current law, most bankruptcy court decisions now permit a trustee to claim the IRC section 121 exclusion. *

Bruce M. Bird, JD, CPA, is a professor of accounting at Richards College of Business, University of West Georgia, Carrollton.

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