Many times the subject of bankruptcy seems baffling in its complexity. Actually the basic principals of bankruptcy are fairly simple even though the federal statuses on bankruptcy are extensive. The reason that the statutes are so complex is because in as effort at social engineering, the lawmakers want to cover every possible contingency. The very complexity of the Bankruptcy Code gives the lawyers ample opportunity to try to obtain interpretation of the law which best serves their clients interest. This results in extensive litigation and occasionally in interpretations of the Code which were not what legislature intended. This on turn results in additional legislation, which results in additional litigation and on and on. Nevertheless, the underlying principals are not as complex as the Code makes them seem. Here we will discuss the personal nature of bankruptcy.
The concept of bankruptcy is an old one in the English common law. If a person could not pay his debts, his creditors hauled him into court, took all of his assets, and used those assets to satisfy their debts. If the assets were insufficient to satisfy the debts, the debtor was taken from the bankruptcy court to debtors' prison. Since this is a rather extreme remedy, Article 1 Section 8 of the U.S. Constitution gives the Congress the right to establish "?.uniform Laws on the subject of Bankruptcies throughout the United States."
As the popularity of debtors' prison declined, the concept of giving the debtor a fresh start became one of the primary purposes of the bankruptcy process. It is important to remember that a bankruptcy is a personal action which at time of discharge gives the petitioner (formerly the debtor) a fresh start. The property owned by the petitioner does not get the fresh start, the individual does.
The fact that bankruptcy is a personal action may shed some light on the effect of a homestead exemption in a bankruptcy proceeding. The bankruptcy code acknowledges the validity of homestead exemption. A homestead exemption is a personal exemption which, in an effort to preserve a person's home, protects a certain amount of an individual's equity in the homestead property. State law determines the extent and effect of a homestead exemption. Thus, if state law says that a person can declare a homestead up to $45,000 and if there is less than $45,000 equity in the property, that equity in the property is protected by the homestead exemption. This principal operates without regard to the Federal Bankruptcy Code.
Filing a Petition for Chapter 7, 11, and 13 Bankruptcy
When a petition for bankruptcy is filed, it is as if the petitioner is saying to the bankruptcy court, "Here are all of my possessions, you figure it out." This is called a chapter 7 bankruptcy. (Chapter 11 and Chapter 13 bankruptcies involve the petitioner creating a plan to pay the creditor's back, and is a different breed of cat.) A trustee is appointed to represent the petitioners' creditors and divvy up the petitioners assets among those creditors. If a states homestead law says that a certain amount of the petitioner's equity in his home cannot be used to satisfy certain debts, the trustee cannot use that equity to pay off creditors. The court is in no better position than the creditors would be. Thus, when the trustee allows the exemption of the petitioner's property, the trustee is saying that whatever equity the petitioner has in his home is protected by the petitioners declaration of homestead. If state law allows a $45,000 homestead, the exemption is $45,000. If the state has a $50,000 limit, the exemption is limited to $50,000 and so on.
The trustee also has the right to determine that a piece of property has too many liens or encumbrances. In this case, the trustee can abandon the property. If the property is exempt or abandoned, it is no longer subject to the bankruptcy, although the petitioner may still benefit from the protection of the automatic stay which prevents anyone from bringing an action against a petitioner while the bankruptcy proceeding is pending.
After the petitioner's property has been divided among the petitioner's creditors, and those debts which can be satisfied have been satisfied, the petitioner is discharged. This means that the creditors cannot look to the petitioner for payment of any remaining debts. This discharge of the petitioner has nothing to do with the petitioner's property. State law determines the effect of any liens recorded against the petitioners property.
The effect of all this is that if property is deemed exempt or abandoned or if the petitioner is discharged and retains title to the property, any recorded liens are still attached to the property and must be reckoned with. In most instances whatever equity the petitioner has in the property will be protected by the declaration of homestead. Had the equity exceeded the amount of equity protected by the homestead, the trustee would have probably used it to satisfy the creditors. Excess equity (or property upon which a homestead cannot be declared) is the usual reason that the trustee will ask the court to authorize the sale of the property free and clear of existing liens. The free and clear part is intended to make the property more attractive to a potential buyer, assuring the highest price and getting the most money to satisfy the greatest number of creditors.
Remember, a bankruptcy relieves the discharged petitioner of his debts. It has no effect on the petitioner's property. Unless the bankruptcy court decides otherwise and issues an order removing the lien of existing encumbrances, the property is still subject to the effect or recorded liens under state law.
By John E. Roush, Broker-Owner Atrium Real Estate Investments. John is a full-time real estate agent specializing in real estate investment and real estate investment education. To contact John send all correspondence to Johnr@investorloft.com © 2005 www.InvestorLoft.com
IRS Tightens Related Party Rules for 1031 Exchanges
IRS Tightens Related Party Rules for 1031 Exchanges
A recent IRS Ruling will now reduce taxpayer flexibility when they complete a 1031 exchange by buying property from a relative.
To be clear, there are two types of exchanges involving relatives. In the simultaneous type you trade deeds. Section 1031 allows you to swap properties tax free with a relative provided both of you then hold the property you receive for at least two years.
In the deferred type of exchange, you sell your property to a third party and use the money to buy your relative's property. Section 1031(f) prohibits such a purchase unless you can prove to the IRS that you had no motive to avoid tax. The new ruling pertains to this deferred type involving a relative.
Prior to this ruling, many exchange professionals assumed that the "no tax avoidance" exception meant that if a related seller of the replacement (let's call it the "new") property pays tax, or is able to sell the property without tax, then you could buy from them even if they are related. So for example if your brother is selling you a house that he owns, and would have no tax liability because he is selling it at a loss, it was felt that your purchase of the property would be allowed because there is no tax avoidance. Ditto if it was his personal residence and the gain is excluded or if your brother merely declares the gain and pays the tax.
The new ruling makes it clear that the IRS sees the purchase of the new property from a related party in a deferred exchange as a violation of the prohibition against deferred related party dealings.
In the Technical Advice Memorandum issued as Private Revenue Ruling 9748006, a son sold an undivided interest in bare land and immediately purchased a residence from his mother. The mother had purchased the residence just prior to its acquisition by the son and had no taxable gain on the sale. The son used a number of arguments making his case that the exchange should stand, the most prominent of which was that there was no tax avoidance in the transaction because the mother had no gain. The IRS disagreed and ruled that the purchase violated Section 1031(f) because the family unit (i.e. the mother and son) ended up with both the house and the cash in completion of the exchange.
One of the sons's other argument was that because he had used a qualified intermediary to handle his exchange; he had purchased the new property from the qualified intermediary, who was not related, rather than from his mother. Since the acquisition of the house from the mother happened simultaneously with the sale of the land, it seems that the only use of the qualified intermediary was to insert an unrelated party between the son and the mother. The IRS stated that the use of a qualified intermediary would not correct an otherwise flawed transaction.
This is the first ruling the IRS has issued concerning deferred related party replacements in a 1031 exchange. It makes it clear that the Service intends to narrowly apply the tax avoidance exemption allowed by 1031(f) in all cases except a direct swap of property. And it imposes a new rule of thumb that might simply be stated as follows:
"If the buyer and the seller are related, and one of the parties ends up with the property and the other ends up with the cash, the exchange will be disallowed".
As with many IRS rulings, it raises more questions than it answers. Most obvious is the question of "what situation would give rise to a 'no tax avoidance' situation". The ruling is also not clear about what the son intended to do with property. The implication I got from reading it was that the son intended to rent the property to the mother. The IRS did not address that issue. And most interesting to me was the fact that this transaction was in effect a reverse exchange since the new property was acquired for the taxpayer before the taxpayer had closed the sale of the old property. No mention was made of that fact. Very interesting indeed.
Who is a "Related Party?
Related persons are tightly defined by the IRS in Sections 267(b) and (c). Below is a brief summary of the definitions. If you have a relationships that is similar to those below, but not mentioned exactly, you should consult your attorney or your CPA to make sure you are not defined as related parties:
Member of your immediate family (e.g., an individual and his spouse, siblings, parents, children);
An individual and a corporation, partnership, estate or trust in which they own, directly or indirectly, more than 50% (by value) of the stock;
Two corporations which are members of the same controlled group;
In determining indirect ownership, an individual includes only his brothers and sisters, spouse, ancestors, and lineal descendants.
The IRS construes these rules very exactly. For example, if you own exactly 50.00% of a corporation you are not related; if you own 50.10% you are.
By John E. Roush, Broker-Owner Atrium Real Estate Investments. John is a full-time real estate agent specializing in real estate investment and real estate investment education. To contact John send all correspondence to Johnr@investorloft.com © 2005 InvestorLoft.com
