Pick Bankruptcy, Take Care of The Tax

The rule that Uncle Sam comes first, in bankruptcy, can be a life saver, even if the debtor is going to lose everything in the process.

I was brainstorming with a colleague about his client who was about to suffer a huge judgment in state court.  There were virtually no other creditors that made bankruptcy otherwise appropriate and the judgment might well be non dischargeable.  There was a paid-for house well over the homestead exemption and stock investments to boot. We were trying to figure out what benefit might flow from filing bankruptcy.

What tipped the scales in my mind toward bankruptcy as opposed to letting the creditor collect under state law?  The capital gains taxes.

The ugly fact about state law collection actions is that the creditor can force a sheriff’s sale of the property, the creditor gets the net sale proceeds, less any exemptions, and the debtor gets the tax bill.  Not a very appealing outcome.

Contrast that to a bankruptcy liquidation:  the trustee sells the asset, pays any taxes triggered by the sale, and THEN the creditor gets paid the balance.

Taxes incurred by the estate are an expense of administration. §503(b)(1)(B) The bankruptcy estate takes the asset with the debtor’s tax basis and with  any tax attributes, such as the principal residence exclusion.

In the case I was considering, it looked like there might be $500,000 in gain on the sale of the house, $250,000 of it taxable.  If the combined state and federal rate on that gain is 25%, the tax would be $62,500.

At a sheriff’s sale, the creditor gets all the non exempt cash and the debtor gets a $62,500 tax bill, having been stripped of the assets from which the tax might be paid.  In bankruptcy, the trustee picks up the tax bill.

The debtor in this scenario may emerge from bankruptcy flat broke, but there won’t be a tax insult to add to his injuries.

Image courtesy of mediaspin.com.

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  1. this doesn’t seem to make any sense.  assuming D owes $500,000 in  a non-dischargeable debt, if D files for bk, not only will the trustee pay the taxes on the sale, they’ll take a fee.  that means the non-dischargeable debt will be paid less than 100% and the balance will still be owed when D emerges from bk.  true they won’t owe any taxes, but they’ll owe more money on the non-dischargeable debt than if the property were liquidated pursuant to a sheriff’s sale.

    if the house is sold at a forced foreclosure, the creditor is paid in full and the D is left with a non-dischargeable tax debt.  but it seems as if a forced sale is going to be a less expensive way to realize the gain in the property and, thus, be a less expensive way to resolve this.

    a negotiated settlement with the creditor would be the best option if possible.

    assuming the debt is non-dischargeable, the debtor does NOT emerge from bk flat broke, but still in debt.

  2. Anonymous says:

    There are no really good options in this case, but personally, I’d rather be dealing with a surviving debt to an individual than have the tax debt survive.  Harder to make deals with the IRS, whereas you can go into state court on exemption issues, etc. post bankruptcy. Also, I’d have greater confidence in the trustee getting fair market value than a sheriff, and I know what the trustee’s fee is….personally I don’t know what kind of expenses might be added to the judgment in state court.

  3. Phil_Rhodes says:

    Hmm, food for thought.  I like that idea.  What about putting the debtor in a Chapter 13 to get the benefit of the automatic stay for 5 years?  This might allow the debtor to get back on his feet at least a little.

    Garth’s comment below isn’t quite accurate, at least under California law.  The judgment creditor can credit bid as much as or as little as it wants at the sheriff’s sale to purchase the real property and still collect the remaining “deficiency.” There’s no equivalent of CCP 580d in a sheriff’s sale.  Plus, the sheriff’s sale isn’t publicized nearly as well as a deed of trust foreclosure sale.  The judgment debtor bears the burden of advertising the sheriff’s sale to ensure that the judgment creditor faces bidding competition.  (I’ve bought houses and other property at sheriff’s sales on credit bids for a fraction of the market value.)

    It’s likely that the sheriff’s sale AND judgment creditor’s attorneys’ fees, if the judgment contains an attorneys’ fees provision, would equal or exceed the bankruptcy trustee’s fee.  The sheriff’s sale cost itself is inexpensive, but the litigation costs for the judgment creditor are high.

    You might just strike a deal with the judgment creditor by doing this in some instances where there isn’t too much bitterness.