Owning a house with over $100K in equity and filing Chapter 7

[quincy]

I don't agree with the never part of that as it is too broad. For a person potentially facing bankruptcy I agree it's a bad idea. But for someone not struggling with debt problems there are instances in which that kind of sale may useful, e.g. as part of estate planning. But there are tax traps for the unwary doing this, so someone considering it should see a tax attorney for assistance with that.

I believe the number two “rule” was an extension of the number one rule. If filing for bankruptcy, you shouldn’t play games with your assets (e.g., hide them, transfer them, sell them cheap) in a misguided effort to avoid paying your creditors.

 

[Taxing Matters]

I believe the number two “rule” was an extension of the number one rule. If filing for bankruptcy, you shouldn’t play games with your assets (e.g., hide them, transfer them, sell them cheap) in a misguided effort to avoid paying your creditors.

Yes, I can see that may be what was intended and of course don't disagree with that. My take on it was that they were stated as independent rules.

 

[quincy]

Yes, I can see that may be what was intended and of course don't disagree with that. My take on it was that they were stated as independent rules.

Ahh. I didn’t read it that way nor do I believe that was what was intended, seeing as how rule two referred back to rule one on creditors.

 

[despritfreya]

I don't agree with the never part of that as it is too broad. For a person potentially facing bankruptcy I agree it's a bad idea. But for someone not struggling with debt problems there are instances in which that kind of sale may useful, e.g. as part of estate planning. But there are tax traps for the unwary doing this, so someone considering it should see a tax attorney for assistance with that.

The reference was in relation to bankruptcy and/or evading a creditor's attempt to collect. However, selling a large asset for less than its value, unless you are completely debt free, can be problematic if and when creditors come knocking. I believe all States have a Fraudulent Transfer Statute. Actual fraud is not necessarily involved. What may be involved in invoking such a statue is the unequal exchange for value. I make money off folks who thought they were ok with such a sale but later find out that underselling an asset when one has debt can be a problem.

Des.

 

[LdiJ]

Let me play the devil's advocate for a moment:

I don't know who put down the down payment on the property, but if it was brother or if there was no down payment needed for some reason, that impacts my argument.

Brother is making the mortgage payment which includes, interest, principal and escrow. (property taxes and homeowner's insurance). I doubt if he has renter's insurance on the property although he might. He did the renovations, and he apparently is taking care of maintenance.

I can just about guarantee that sister has not been including a Schedule E for a rental property on her tax return for the last 7 years. However, equity in the property has been building up due to the principal portion of the mortgage payment as well as appreciation. Therefore, if the argument prevailed that brother is a tenant, and sister a landlord, if she were to sell the property or the sale was forced through bankruptcy, she would be selling it as a landlord. Since a landlord must recapture depreciation, allowed or allowable, sister would have a very hefty tax bite upon the sale of the house.

If sister was selling the house on contract, then she has a different tax problem. She should have been reporting the interest and principal paid to her on her taxes on an annual basis. She would not have a depreciation recapture problem and she would not have a problem if it was selling at below today's market because the price would have been established 7 years ago, not today.

In either scenario though, sister has a tax problem. However, if it weren't for the laws in so many states that require real estate transactions to be in writing to be enforceable, the actions of the parties would clearly show this as a contract sale. Sister has certainly profited (on paper) by brother's payments and maintenance of the property based on the gained equity.

25k is a significant amount of debt but not an insurmountable amount of debt. No matter what the scenario is, if sister cannot service her debt brother's continued use of the house and possible future ownership (or current ownership in his eyes) is at risk.

So, if these were my family members or clients, I would be suggesting that the two of them sit down and have a serious discussion about how the both of them screwed things up 7 years ago by not doing things right, and how they can fix it going forward so that the problems are mitigated.

Some ideas:

Sister gets a HELOC to pay her debt (assuming that she can qualify for one with her present financial circumstances).

Brother and sister do a contract now, based on current market value, and give brother credit as a downpayment/sweat equity for the money he has put towards the principal and maintenance/renovation and his labor. Or, perhaps partial credit depending on other details unknown to us or because the situation has gone on many years longer than sister anticipated. Address the home equity loan in the contract with a stipulation that sister must pay it off before final settlement or during final settlement.

Another idea:

Same sit down discussion about reality, but they agree that sister sells the house now, gives him some money for his contributions to the equity gained in the property, and takes what she needs for taxes and debt and they go their separate ways financially. Brother won't like it, but he will like it even less if he loses out completely because sister is forced into bankruptcy (if the situation is dire enough for that possibility).

Both of them should talk to attorneys before proceeding in any direction on this.

Sister will have to understand that going forward she has to address the installment payments on her taxes and pay any tax due.

 

[Taxing Matters]

The reference was in relation to bankruptcy and/or evading a creditor's attempt to collect. However, selling a large asset for less than its value, unless you are completely debt free, can be problematic if and when creditors come knocking. I believe all States have a Fraudulent Transfer Statute. Actual fraud is not necessarily involved. What may be involved in invoking such a statue is the unequal exchange for value. I make money off folks who thought they were ok with such a sale but later find out that underselling an asset when one has debt can be a problem.

Des.

Most financial transactions have some degree of risk, and selling a property to a relative for less that full value is one of them. For a lot of people, it wouldn't be wortwhile even just looking at economics of it. For others, there are the potential risks that come with creditor rights. I never said it was a suitable transaction for everyone or even most people. But there are some for whom it is a useful way to accomplish their goals. As has already been mentioned, before doing it an attorney and tax professional ought to be consulted to make sure one doesn't step one a trap that he or she had no idea might be there. My point, for those unfamilar with these kinds of transactions, is that just hearing about the times when it didn't work (and there are a lot of them because people tend to treat it as a DIY project) doesn't mean it can't be useful.

 

[Taxing Matters]

Therefore, if the argument prevailed that brother is a tenant, and sister a landlord, if she were to sell the property or the sale was forced through bankruptcy, she would be selling it as a landlord. Since a landlord must recapture depreciation, allowed or allowable, sister would have a very hefty tax bite upon the sale of the house.

The depreciation recapture is the same whether they filed their schedules E with their returns or not, of course.

Depending on the details of the transaction, there may be imputed rental income if market rate rent was not paid. However, assuming that the owner had filed returns every year and had not understated his/her income by more than 25% and that there are no indications of fraud the statute of limitations (SOL) for the IRS to assess the tax based on that imputed rent then the statute of limitations (SOL) for the IRS to assess the tax for the imputed income will be limited to the last three years returns. For the periods still open, the IRS may assess additional tax for the rental income those years, and the taxpayer may amend his/her return to claim the depreciation deductions for those years.

But change the facts even a little and the result might change. The exact facts matter as to the tax treatment of the deal and how the court will treat it. There are all kinds of different results one might get, some favorable to the government and some favorable to the government. We could spin out proposed scenarios all day on that if we wanted.

The problem is doing the transaction as a DIY project and skipping over getting legal and tax advice. But if they get advice before they start, have the necessary contracts and other documents executed before or at the time the rental activity starts, and they treat it on their returns and in other dealings consistent with the arrangement they made they'll have a very good idea of what to expect and a much better chance of the deal of passing muster with the IRS and the courts.

 

[quincy]

… There are all kinds of different results one might get, some favorable to the government and some favorable to the government. We could spin out proposed scenarios all day on that if we wanted. …

The results don’t sound too different.

 

[Zigner]

The results don’t sound too different.

Toe the line, q. Toe the line.

 

[Taxing Matters]

?

I am just not seeing how anything despritfreya has posted in this bankruptcy thread has been confusing.

I think that's because, in part, you are familiar with bankruptcy. But a lot of people out there aren't and may not distinguish between information that is intended only with respect to bankruptcy and other situations unless that's specifically stated. I've dealt with hundreds of taxpayers over the years who, because they had only a rudimentary understanding of the transaction they find themselves in trouble. Those taxpayers often were confused thinking, in part, that regulations that applied to only a certain specific fact pattern or specific individuals instead thought the rules applied to everyone. That kind of confusion is exactly why Congress passed the "Plain Writing Act of 2010" to push agencies to write regulations in language that most Americans can understand, and part of that is avoiding implied facts or conclusions that professionals in that area would pick up on but that consumers would not. That kind of problem can crop up in any kind of writing of a technical or complex subject that will be read by people who are not specialists. It's easy for professionals to do that because when writing only for professionals in the particular subject they can safely make some assumptions about what their readers probably know. But when writing for a more general audience one has to think specifically about how wide audience will be and write their rules, etc., clearly stating everything rather than hope the reader catches the implication. It's not something that most professionals can instantly do. It took me a some time and practice writing letter rulings, regulations, revenue procedures, etc to learn how to do a better job of explaining things in a way most taxpayers would readily understand.

 

[Taxing Matters]

The results don’t sound too different.

That's because you've not been presented in this thread with all the variations one might have in transactions like this. When we are looking at one specific set of facts and assumptions then of course the results will sound much alike. But make other changes and the result may change significantly. There have been circumstances in which something as small as where a comma was placed made a significant difference in outcome. Comma placement isn't something most readers would catch and writing in a way in which a single comma makes a noticeable difference ought to be avoided for that reason. I will admit that I'm more sensitive to this than are a lot of other people but only because part the work I did at IRS forced me to think about writing and speaking more plainly when dealing with the public than I had to do in my in house legal and technical writing. While I try to do my best, I still end up using technical terms or a writing style that is used by a particular group when addressing a wider audience. At least for me, writing in plain language on areas I know very well is a challenge because my mind first jumps to the legal/technical way to say it. It's still worth the effort to try.

 

[quincy]

I think that's because, in part, you are familiar with bankruptcy. But a lot of people out there aren't and may not distinguish between information that is intended only with respect to bankruptcy and other situations unless that's specifically stated. I've dealt with hundreds of taxpayers over the years who, because they had only a rudimentary understanding of the transaction they find themselves in trouble. Those taxpayers often were confused thinking, in part, that regulations that applied to only a certain specific fact pattern or specific individuals instead thought the rules applied to everyone. That kind of confusion is exactly why Congress passed the "Plain Writing Act of 2010" to push agencies to write regulations in language that most Americans can understand, and part of that is avoiding implied facts or conclusions that professionals in that area would pick up on but that consumers would not. That kind of problem can crop up in any kind of writing of a technical or complex subject that will be read by people who are not specialists. It's easy for professionals to do that because when writing only for professionals in the particular subject they can safely make some assumptions about what their readers probably know. But when writing for a more general audience one has to think specifically about how wide audience will be and write their rules, etc., clearly stating everything rather than hope the reader catches the implication. It's not something that most professionals can instantly do. It took me a some time and practice writing letter rulings, regulations, revenue procedures, etc to learn how to do a better job of explaining things in a way most taxpayers would readily understand.

Actually, I asked for bankruptcy attorney despritfreya to look over this thread specifically because I am not that familiar with bankruptcy.

I personally think that it is likely that any visitor to this site who reads a thread in the Consumer Bankruptcy section of the forum titled “Owning a house with over $100K in equity and filing Chapter 7” probably realizes the information provided is about bankruptcy. But I could be wrong.

 

[despritfreya]

Folks, please chill. We all have our own opinions and experiences. Mine are from the prospective of being a bk attny who typically deals with more complex problems facing debtors and in many instances, doing damage control. There may not be a right or wrong answer to the issues being raised, inside or outside of a bk. There is only what may happen after the deal is done.

Des.