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For a chapter 7 BK, you generally must file a petition with the court who then appoints a trustee to manage your bankruptcy estate, including liquidating any non-exempt assets after having a creditors meeting, etc. The bankruptcy estate is, for IRS purposes, a taxable entity separate than it's owner. Assets transferred to the bankruptcy estate and sold by the trustee and/or income generated from those assets are therefore reported on the Form 1041 return, not your own personal Form 1040 return. The income tax liability associated with the bankruptcy estate's assets is an administrative / priority claim that will get paid ahead of general unsecured creditors, but any remaining liability will not pass back to the debtor.
When it comes to your Form 1040, you do have an election for a short tax year. This takes the income tax up to the date of bankruptcy and includes the liability against the bankruptcy estate's assets. Any remaining income tax debt will not be able to be discharged if the amount is not paid from the bankruptcy estate's assets, however. If you do not elect two short years, then your income tax for the period proceeding the BK will not be included in the BK estate. Making this decision will depend on your personal facts and circumstances, so see a local professional.
In a case where you are personally liable, you may want to do a short sale to avoid all the extra attorney's fees, interest, and other costs that are associable with a foreclosure. These amounts can be included in the resulting foregiven debt income.
The specific IRS rule regarding forgiveness of debt income (IRC 108), does not apply to capital gains, no. You are correct in that regard. Outside of your bankruptcy, you would be looking to prove insolvency, which requires a detailed analysis of all of your assets (including exempt assets like retirement accounts), in addition to any reduction of basis considerations for your property.
The character of your gain, if applicable, is going to be based on whether or not your debt was recourse debt (ie, were you personally liable?). If you weren't liable, the amount you would realize on the 'sale' includes all the forgiven debt. If you were liable, then you only realize as part of the 'sale' an amount equal to the fair value of the asset sold, with the remaining balance as forgiveness of debt income taxed at ordinary rates to the extent your IRC 108 exclusion does not apply.
I hope this is helpful. Thank you for your question.
IRS Publication 908 - Bankruptcy Tax Guide
"Individuals in Chapter 7 or 11
If the debtor is an individual who files for bankruptcy under chapter 7 or 11, the bankruptcy estate is treated as a new taxable entity, separate from the individual taxpayer.
The estate in a chapter 7 case is represented by a trustee. The trustee is appointed under the Bankruptcy Code to administer the estate and liquidate any nonexempt assets of the estate. In chapter 11, the debtor often remains in control of the assets as a "debtor-in-possession" and acts as the bankruptcy trustee. See Taxes and the Bankruptcy Estate, later.
If the debtor filed a chapter 7 or 11 case, the debtor must file a Form 1040 for the tax year involved. The bankruptcy trustee files a Form 1041 for the bankruptcy estate. If the debtor is in chapter 11 bankruptcy and remain as the debtor-in-possession, the debtor must file both a Form 1040 and the Form 1041 for the bankruptcy estate (if the estate meets the return filing requirements).
If a husband and wife file a joint bankruptcy petition and their bankruptcy estates are jointly administered, their estates must be treated as two separate entities for tax purposes. Two separate tax returns must be filed (if they separately meet the filing requirements).
If the debtor is an individual debtor in a chapter 7 or 11 case, the debtor may be able to elect to close the debtor's tax year for the year in which the bankruptcy petition is filed, as of the day before the date on which the bankruptcy case commences. If the debtor makes the election, the debtor's tax year is divided into 2 short tax years of less than 12 months each. The first year ends on the day before the commencement date and the second year begins on the commencement date. If the election is made, the debtor federal income tax liability for the first short tax year becomes an allowable claim against the bankruptcy estate as a claim arising before the bankruptcy filing. The tax liability for the first short tax year, not subject to discharge under the Bankruptcy Code, can be collected from the estate.
If the debtor does not make an election to end the tax year, the commencement of the bankruptcy case does not affect the debtor's tax year. Also, no part of the debtor's income tax liability for the year in which the bankruptcy case commences can be collected from the bankruptcy estate. The debtor cannot make a short-year election if the debtor has no assets in the bankruptcy estate other than exempt property.
"Income of the estate in chapter 7 cases of individuals. The gross income of the bankruptcy estate includes any of the debtor's gross income to which the estate is entitled under the Bankruptcy Code. It also includes income generated by the bankruptcy estate, from property in the estate, after the commencement of the case.
Gross income of the estate does not include amounts received or accrued by the debtor before the commencement of the case. Additionally, gross income of the estate in a chapter 7 case does not include any income that the debtor earns after the bankruptcy petition date."
"In Chapter 7 bankruptcy, the debtor files a petition with the court, which includes detailed financial information about his assets, debts, and income, and a list of the assets claimed as exempt. The papers filed with the court are executed under penalty of perjury. The court process usually takes about 3-4 months.
The Role of the Chapter 7 Trustee
The court appoints a trustee to
Foreclosures and Repossessions
If you do not make payments you owe on a loan secured by property, the lender may foreclose on the loan or repossess the property. The foreclosure or repossession is treated as a sale or exchange from which you may realize gain or loss. This is true even if you voluntarily return the property to the lender. You also may realize ordinary income from cancellation of debt if the loan balance is more than the fair market value of the property.
Amount realized on a nonrecourse debt. If you are not personally liable for repaying the debt (nonrecourse debt) secured by the transferred property, the amount you realize includes the full debt canceled by the transfer. The full canceled debt is included even if the fair market value of the property is less than the canceled debt.
Amount realized on a recourse debt. If you are personally liable for the debt (recourse debt), the amount realized on the foreclosure or repossession does not include the canceled debt that is your income from cancellation of debt. However, if the fair market value of the transferred property is less than the canceled debt, the amount realized includes the canceled debt up to the fair market value of the property. You are treated as receiving ordinary income from the canceled debt for the part of the debt that is more than the fair market value.
Myth #5 - "I have no assets, so I'm insolvent and don't need to worry about the tax consequences of a short sale."
This is true as far as it goes: Section 108 of the IRC indeed provides for excluding forgiven debt from income to the extent the seller is insolvent. However, just because a seller is upside down on their property doesn't mean they're insolvent for this purpose. The extent of insolvency for IRS purposes is the difference between the outstanding liabilities and fair market value of the assets (this is all assets, including protected assets such as retirement accounts) owned by the Seller on the date of the short sale. It is virtually impossible to reach a conclusion on insolvency for this purpose without a detailed analysis of all of the seller's assets and liabilities, including those unrelated to the property, as well as the basis reduction that would occur in the short sale.
The good news on this one is that, unlike the MDFRA, the insolvency exclusion applies to investors. This is an important aspect to explore for them particularly.
Myth #9 - "I'll just let the property go into foreclosure, rather than do a short sale, to avoid the taxes."
This wouldn't necessarily help you. The tax is the same regardless of how the debt forgiveness comes about: a short sale, principal reduction loan modification, deed in lieu of foreclosure or foreclosure all have the same effect. The only potential difference is the amount of the debt forgiven. For example, default interest, attorney's fees and costs continue to add up during a foreclosure, which might be avoided or reduced in a short sale, typically making the unpaid balance of the loan (and resulting debt forgiveness) in a foreclosure higher than if a short sale were completed.
Myth #10 - "If I end up owing tax, I'll just file bankruptcy."
Chances are, you'll still owe the tax. Income tax is not typically discharged in bankruptcy. While there are a few exceptions, most will not apply in these cases.
The tax implications of foreclosures and short sales are more complex than mass media would lead us to believe, and there is considerable misunderstanding among property owners as to what the rules are and how they would apply.."
-JoAnn M. Koontz, Esq., CPAYesner & Boss, P.L.
How Current is This?
(a) Exclusion from gross income
(1) In general Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if-
(A) the discharge occurs in a title 11 case,
(B) the discharge occurs when the taxpayer is insolvent,
(C) the indebtedness discharged is qualified farm indebtedness,
(D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or
(E) the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2013.
1. That is important. It's 2010, so your 2009 bankruptcy is probably irrelevant. Once the discharge papers have been filed, it's over so to speak.
2. I'm not sure you are personally liable for the debt (shouldn't be after bankruptcy I would think) so non-recourse debt I assume (see above for the treatment of non-recourse debt) and forgiveness of debt income is not likely in lieu of capital gains. I am also not privy to the specifics of your bankruptcy, or why if your rental wasn't sold or otherwise claimed by creditors via your trustee, but if you kept title to the rental and the lenders kept their leins after the discharge, then you are depending on the IRC 108 insolvency exclusion (tough to prove, IRS recommends professional guidance, see below). Your bankruptcy would be irrelevant on a technical level, again, after discharge and in a different tax year all together. It is reasonable to expect someone to be solvent (or at least not that insolvent) immediately following a bankrupcty.
3. You'll still owe capital gains, per above. Again, the insolvency provisions of IRC 108 do not apply to capital gains, but rather, "discharged indebtedness." Perhaps you can work out a payment plan with the IRS. In an extreme case (not likely), you may be able to win an offer in compromise. Bankruptcy is generally not a means of ridding yourself of (new) tax debt, though certain tax debts can be relieved as part of a bankruptcy, yes, also noting the administrative aspects of the bankruptcy estate in relation to asset sales / foreclosures, the estate being a separate taxable entity (again, see above).
I warned about the additional legal, interest, and other fees associated with a foreclosure as opposed to a short sale. In general, a short sale is quicker too. For tax purposes, your tax treatment is essentially the same, though realize that some additional fees (like some of those associable with a foreclosure as mentioned) can be included in the forgiven debt and therefore the amount realized for tax purposes (non-recourse or recourse, see above).
Under all the possibilities you give (short sale, foreclosure, deed in lieu), your sale price is still going to be related to the loan balance and fair value of the property, per above. The character of your gain is still going to depend on whether or not you are personally liable for the forgiven debts (again, see above). The insolvency exclusion will also apply to all three situations the same, though not for capital gains, just on discharged indebtedness, again, per above. Your bankruptcy, having been discharged in 2009 and with me unattuned to the details, appears to not be relevant for purposes of determining your 2010 taxable income to the extent you are not confusing the bankruptcy estate's assets / liabilties with those of your own.
Thank you again.
PS - See here, and note the "Insolvency Worksheet" on page 6:
Form 982 OMB No. 1545-0046
( Rev. March 2009)
Reduction of Tax Attributes Due to Discharge of
Indebtedness (and Section 1082 Basis Adjustment)
Purpose of Form
Generally, the amount by which you benefit from the
discharge of indebtedness is included in your gross income.
However, under certain circumstances described in section
108, you can exclude the amount of discharged indebtedness
from your gross income.
You must file Form 982 to report the exclusion and the
reduction of certain tax attributes either dollar for dollar or
331⁄3 cents per dollar (as explained below).
1. No. I suggested that the legal fees, interest, and other costs associable with a foreclosure could be included in the loan balance with a foreclosure, thus increasing your amount realized on the 'sale' for tax purposes. It will be a wash, assuming all these costs are also deductible to you then for your rental property in its final year, and in general. As for the capital gains rates, yes, I believe capital gains rates will go up in 2011, save for action by Congress.
2. Your understanding is wrong, sorry (again, see non-recourse debt above, the very definition of which, as stated, is that you are not liable). I have given you the publications above also, Form 982 with instructions, quoted directly IRC 108 for your insolvency exclusion, and mentioned the idea of a payment plan or offer in compromise (aka, OIC, the next closest thing to an insolvency exclusion, so to speak, though unlikely in lieu of a payment plan).
I will quote for you some of the example calculations from the IRS pub above:
Chris bought a new car for $15,000. He paid $2,000 down and borrowed the remaining $13,000 from the dealer's credit company. Chris is not personally liable for the loan (nonrecourse debt), but pledges the new car as security. The credit company repossessed the car because he stopped making loan payments. The balance due after taking into account the payments Chris made was $10,000. The fair market value of the car when repossessed was $9,000. The amount Chris realized on the repossession is $10,000. That is the debt canceled by the repossession, even though the car's fair market value is less than $10,000. Chris figures his gain or loss on the repossession by comparing the amount realized ($10,000) with his adjusted basis ($15,000). He has a $5,000 nondeductible loss.
Abena paid $200,000 for her home. She paid $15,000 down and borrowed the remaining $185,000 from a bank. Abena is not personally liable for the loan (nonrecourse debt), but pledges the house as security. The bank foreclosed on the loan because Abena stopped making payments. When the bank foreclosed on the loan, the balance due was $180,000, the fair market value of the house was $170,000, and Abena's adjusted basis was $175,000 due to a casualty loss she had deducted. The amount Abena realized on the foreclosure is $180,000, the debt canceled by the foreclosure. She figures her gain or loss by comparing the amount realized ($180,000) with her adjusted basis ($175,000). She has a $5,000 realized gain.
Also, for posterity:
Amount realized on a recourse debt. If you are personally liable for the debt (recourse debt), the amount realized on the foreclosure or repossession does not include the canceled debt that is your income from cancellation of debt. However, if the fair market value of the transferred property is less than the canceled debt, the amount realized includes the canceled debt up to the fair market value of the property. You are treated as receiving ordinary income from the canceled debt for the part of the debt that is more than the fair market value. See Cancellation of debt, later.
Assume the same facts as in the previous Example 1, except Chris is personally liable for the car loan (recourse debt). In this case, the amount he realizes is $9,000. This is the canceled debt ($10,000) up to the car's fair market value ($9,000). Chris figures his gain or loss on the repossession by comparing the amount realized ($9,000) with his adjusted basis ($15,000). He has a $6,000 nondeductible loss. He also is treated as receiving ordinary income from cancellation of debt. That income is $1,000 ($10,000 - $9,000). This is the part of the canceled debt not included in the amount realized.
Assume the same facts as in the previous Example 2, except Abena is personally liable for the loan (recourse debt). In this case, the amount she realizes is $170,000. This is the canceled debt ($180,000) up to the fair market value of the house ($170,000). Abena figures her gain or loss on the foreclosure by comparing the amount realized ($170,000) with her adjusted basis ($175,000). She has a $5,000 nondeductible loss. She also is treated as receiving ordinary income from cancellation of debt. (The debt is not exempt from tax as discussed under Cancellation of debt, below.) That income is $10,000 ($180,000 - $170,000). This is the part of the canceled debt not included in the amount realized.