Taxation of Foreclosure Sales

This is a post from my friend Dennis McGoldrick in Torrance, Cal.  Dennis is a former chapter 7 trustee, a certified bankruptcy specialist and one of the best bankruptcy lawyers I know. The issue of who is taxed on the gain on the foreclosure sale when a bankruptcy has been filed can get complicated. As I tell my students over and over, know when to call a specialist! This is a complicated area. Do not depend on this short summary. Make sure you have all the facts, etc. etc.

Jon Hayes

"Taxation of foreclosure sales is one of the toughest questions. The entity who/which owns the property at the time of the sale is the entity who/which is responsible for the tax on the gain. If a foreclosure sale occurs before the bankruptcy, the debtor is liable for the tax, as the sale is really a debtor sale of the property. The Foreclosure Trustee sells the property under a power of sale given by the debtor.

In order to avoid tax in this situation, the bankruptcy must be filed before the sale, and must not close before the sale. Under section 541, the filing of the bankruptcy creates an estate and the estate then is the owner and seller of the property (the power of sale would also inure to the estate). The estate is responsible for its own taxes and files its own tax return. Trapping the foreclosure sale in the estate is therefore paramount when there is a taxable gain. Under section 349, the closing of a bankruptcy gives (abandons) all of the unadministered property of the estate back to the debtor. As a result, a foreclosure sale after a bankruptcy would be taxable to the debtor. If the debtor does not live in any of the properties to be foreclosed, the debtor will not be able to claim the $250,000 tax free gain (requires living in the property for 2 years). So you must trap the sales of properties which will generate a gain in the estate. If there is no other asset to administer, the trustee will not take notice of the foreclosure as the trustee will have no real income and cannot pay any tax, so no tax return for the estate is ever filed. The real problem comes when/if the trustee has another asset to administer. A competent trustee will realize the foreclosure sales will generate a tax, so the trustee will move to abandon the foreclosure properties back to the debtor."

Dennis