1998 DECISION: TRUSTEE MAY USE SECTION 121 TO EXCLUDE GAIN ON RESIDENCE SALE.

                   UNITED STATES BANKRUPTCY COURT

[1] The issue is whether gain on the sale of the Debtor's residence is excluded from gross income of this Chapter 7 estate to the extent provided by I.R.C. section 121, as amended by The Taxpayer Relief Act of 1997, Pub. L. No. 105-34, section 312(a), 111 Stat. 836-37 (Aug. 5, 1997). The section 121 exclusion is available to the bankruptcy estate.

I. FACTS

[2] Freda Bradley filed Chapter 13 on October 28, 1996. On April 4, 1997, her case converted to Chapter 7. The Chapter 7 Trustee sold the Debtor's residence on October 3, 1997, resulting in a gain of $77,106.

[3] On the bankruptcy estate's 1997 income tax return, the Trustee declared the gain on the sale of the Debtor's residence but excluded the gain from income pursuant to I.R.C. section 121. By letter dated February 13, 1998, the Internal Revenue Service rejected the estate's return "pending a determination regarding the position you have taken on the I.R.C. Section 121 exclusion."

[4] The Trustee filed a Motion for Determination of Tax Liability pursuant to 11 U.S.C. section 505(b). The Trustee asserts that I.R.C. section 121, as amended by The Taxpayer Relief Act of 1997, ¹ excludes from income gain on the sale of a debtor's residence by a Chapter 7 trustee if the debtor would have qualified for the exclusion had the debtor sold the property. The Internal Revenue Service responds that the section 121 exclusion is personal to the debtor and not available to a bankruptcy estate. Without the exclusion, the estate's tax liability will be $12,045.

II. DISCUSSION

[5] Section 1398 of the Internal Revenue Code fixes these rules for calculating income taxes for an individual Chapter 7 debtor's estate:

     (c) Computation and payment of tax; basic standard deduction. --

[6] A plain reading of I.R.C. section 1398 entitles the Chapter 7 estate of an individual debtor to exclude from gross income the gain on the sale of a residence if that gain would have been excluded were the taxpayer the debtor. Section 1398(c) states that "taxable income of the estate shall be computed in the same manner as for an individual." Taxable income "means gross income minus the deductions allowed by this chapter (other than the standard deduction)." I.R.C. section 63(a). "Gross income" is defined in I.R.C. section 61 as "all income from whatever source derived" except as provided in I.R.C. sections 101-139. ² Sections 101 through 139 contain "items excluded from gross income." Section 121 excludes from gross income the gain on the sale of a personal residence under certain circumstances:

     121. Exclusion of gain from sale of principal residence.

[7] There is no dispute that this Debtor would be entitled to the section 121 exclusion had this residence been sold by the Debtor rather than by the Chapter 7 Trustee. Section 1398(c) compels the same tax treatment of the sale by the bankruptcy estate. Section 1398(f)(1) confirms that "the estate shall be treated as the debtor would be treated" with respect to an asset that transfers from the debtor to the bankruptcy estate. I.R.C. section 1398(f)(1).

[8] Other courts have concluded that I.R.C. section 1398 entitles an individual Chapter 7 estate to the section 121 exclusion. See In re Popa, 218 B.R. 420 (Bankr. N.D. Ill. 1998); see also In re Munster, Case No. 97-51313-293, slip op. (Bankr. E.D. Mo. June 12, 1998) (sustaining Chapter 13 trustee's objection to confirmation on ground that best interests of creditors test includes gain on sale of debtors' residence available to Chapter 7 trustee pursuant to I.R.C. section 121). As explained by Judge Barliant in Popa:

          The authority for the estate's use of the section 121 IRC

[9] Popa declined to follow two pre-1997 decisions that denied use of the section 121 exclusion by a bankruptcy estate. See In re Barden, 205 B.R. 451 (E.D.N.Y. 1996), aff'd mem., 105 F.3d 821 (2d Cir. 1997) (per curiam); In re Mehr, 153 B.R. 430 (Bankr. D.N.J. 1993). Popa attributed its different result "in part to the 1997 amendments to section 121 [], but primarily [to the] Court's disagreement with the analysis of [I.R.C.] section 1398 [] applied by the other courts." Popa, 218 B.R. at 426.

[10] Prior to the Taxpayer Relief Act of 1997, I.R.C. section 121 recognized a one time exclusion from gross income of up to $125,000 of gain for taxpayers 55 years of age and older on the sale of property used as the taxpayers' principal residence for three of the past five years. The exclusion required election by the taxpayer. I.R.C. section 121(a) (1994 and Supp. 1996). The Taxpayer Relief Act of 1997 expanded the exclusion in section 121. The Act eliminated age as a condition, permitted more than one use of the exclusion during a taxpayer's lifetime, increased the amount of the exclusion, reduced the residential use period to two years, and made the exclusion automatic.

[11] Popa accurately observes that the 1997 amendments to section 121 undermine the policy arguments in Mehr and Barden against use of the exclusion by a bankruptcy trustee. More importantly, Popa's construction of I.R.C. section 1398 is true to the plain meaning of the words in that section, gives effect to all of its subsections, and avoids the dead spots and lapses of logic created by the construction in Mehr and Barden. Popa, 218 B.R. at 426-27.

[12] That the exclusion in section 121 is available to a bankruptcy estate is consistent with reported cases interpreting other aspects of section 1398. For example, with respect to a bankruptcy estate's gross income, section 1398 provides that "each taxable year [gross income] shall include the gross income of the debtor to which the estate is entitled under title 11 of the United States Code[,]" which amount does not include "any amount received or accrued by the debtor before the commencement date . . . ." I.R.C. section 1398(e)(1) (emphasis added). The estate's gross income is in part derivative of the debtor's gross income. See Erickson v. United States (In re Bentley), 916 F.2d 431, 432 (8th Cir. 1990). An "estate [becomes] entitled to any unrealized gain to which the debtor would have been entitled upon commencement of the bankruptcy proceedings under sections 1398(g) and 1398(e)(1)." Id. at 432. See also Sticka v. United States (In re Sturgill), 217 B.R. 291, 295 (Bankr. D. Or. 1998) ("Congress has . . . determined that tax liability arising from income items such as unrealized gain on property of the estate shall be borne by the estate, even if the gain may be said to have accrued prepetition."). Where the unrealized gain would not have been included in the debtor's gross income upon realization, section 1398(e)(1) compels the same treatment of the realized gain in the hands of the estate. This theme continues in I.R.C. section 1398(e)(3) which "states that the determination of whether or not any amount paid by the estate is deductible shall be made as if the amount were paid or incurred by the debtor, and as if the debtor were still engaged in the trades and businesses, and in the activities, the debtor was engaged in before the commencement of the case." In re Vale, 204 B.R. 716, 745 (Bankr. N.D. Ind. 1996). See also Sturgill, 217 B.R. at 296 ("The trustee steps into the shoes of the debtor with respect to questions regarding deductions, credits, and employment taxes."). Section 1398 effects for the bankruptcy estate, the same tax consequence that would befall the debtor outside of bankruptcy. See Popa, 218 B.R. at 427 (citing In re Kochell, 804 F.2d 84, 85 (7th Cir. 1986)). ³

[13] Use of the section 121 exclusion by a Chapter 7 estate is consistent with the position taken by the IRS with respect to decedents' estates. In Revenue Ruling ⁴ 82-1, 1982-1 C.B. 11, the IRS concluded: "The gain from the sale of the decedent's personal residence is excludable to the extent provided under section 121 of the Code if the election is made by the executor on a decedent's final Federal Income Tax Return (Form 1040)." Rev. Rul. 82-1, 1982-1 C.B. 11. The Service resolved:

     Consistent with the extension of rights and privileges accorded

[14] The Barden court conceded that analogy to this Revenue Ruling was "an interesting one," but concluded "in the Court's view it does not recognize important distinctions between a decedent's estate and a bankruptcy estate." Barden, 205 B.R. at 454. Those important differences, Barden stated, are the bankruptcy trustee's obligations to creditors to maximize their distribution from the estate, the existence of two taxable entities in the debtor and the estate, and the potential conflict between the estate and the debtor upon the former's use of the (then) one time exclusion.

[15] These differences are not compelling. The potential conflict between the estate and the debtor/taxpayer was eliminated by the 1997 amendments to section 121. That there will be two taxpayers, the debtor and the bankruptcy estate, presents no obvious mark of distinction. There is no possibility of double accounting because the exclusion follows the property into the bankruptcy estate. Both a bankruptcy trustee and an executor of an estate are fiduciaries; both are obligated to obtain the maximum return for their beneficiaries. The principal beneficiaries of a decedent's estate may be the decedent's creditors.

[16] The government urges the position in Mehr and Barden that section 121 is the "equivalent of a tax attribute" which would have been specifically identified in section 1398(g) had Congress intended a bankruptcy estate to qualify for the exclusion. Barden, 205 B.R. at 455.

     The phrase "tax attribute" is not defined in the I.R.C. The

[17] Finally, to allow a bankruptcy estate to exclude gain from the sale of a debtor's residence promotes the public interest in a responsible bankruptcy system and does not frustrate any clearly defined federal policy. Popa explained:

     A taxpayer with substantial unsecured debts and equity in a

III. CONCLUSION

[18] The gain on the sale of an individual Chapter 7 debtor's residence is excluded from gross income of the debtor's bankruptcy estate to the extent provided by I.R.C. section 121. The Trustee's use of the section 121 exclusion on the estate's 1997 federal tax return was proper. An appropriate order will be entered.

[19] Dated this 16th day of July, 1998.

                                   Keith M. Lundin

² Section 61 of the Internal Revenue Code provides:

     (a) General definition. -- Except as otherwise provided in this

⁴ "Although a revenue ruling is not entitled to the deference accorded a statute or a Treasury Regulation, a revenue ruling is entitled to some deference unless it conflicts with the statute it supposedly interprets or with that statute's legislative history or if it is otherwise unreasonable." Cen Tra, Inc. v. United States, 953 F.2d 1051, 1056 (6th Cir.1992) (internal quotations and citations omitted).

⁵ Mehr, Popa observed, read subsection (g)(6) to only supplement the trustee's use of other tax attributes enumerated in section 1398(g). Popa appropriately disagreed because none of the attributes listed in section 1398(g)(1)-(5), (7)-(8) require consideration of the attributes recognized in subsection (g)(6) -- holding period, basis or character. Each attribute enumerated in section 1398(g)(1)-(5) is available to the estate without regard to subsection (g)(6). Subsection (g)(6), Popa concluded, "simply contains other items of the debtor to which the estate succeeds, without limitation." Popa, 218 B.R. at 427.