In chapter 7 and chapter 11 New York bankruptcy, a bankruptcy estate is created and then either liquidated or managed for the creditors. In chapter 7, the estate is controlled by the trustee; in chapter 11, it’s managed by the debtor in possession or a trustee if appointed by the bankruptcy court.
It’s easy to look at the assessed value of the assets in the bankruptcy estate, compare them with the debtor’s debts, and then do the math. However, this thinking misses a crucial intervening step: taxes—particularly those on capital gains. Just as if the property were sold by the debtor outside of bankruptcy, the bankruptcy estate pays taxes too. Debtors in chapter 7, though, usually don’t need to pay attention to taxes on asset transfers for a few reasons: One, the trustee manages the bankruptcy estate; two, the bankruptcy estate is liquidated fairly quickly; and three, it’s usually very small.
Chapter 11 debtors in possession, by contrast, do need to pay attention to capital gains taxes on the bankruptcy estate’s property when they consider selling it to satisfy creditors. If a significant portion of the sold asset’s value consists of unearned appreciation since the debtor first purchased it, a large amount of its sale value will need to go to the government. Moreover, because New York has higher capital gains tax rates than other states, they can play a bigger role than debtors might expect.
Importantly, the capital-gains tax rate the bankruptcy estate pays on an asset sale is based on the debtor’s income-tax bracket, as though the debtor still owned the property. Using income as the baseline for the capital-gains tax rate may seem confusing, but the idea is to ensure that older people selling property pay a lower rate than younger people with high incomes. (It may end up also protecting very wealthy people who have little regular income, but that’s a different issue.)
Another factor is how long the debtor has owned the property. The tax rate is lower for assets that have been held over a long term (more than a year), and it’s higher for anything held for shorter periods. According to the Tax Foundation, in 2013, New Yorkers in the highest income-tax bracket pay an effective, combined capital-gains tax of 31.4 percent.
On the other hand, there is some good news for debtors. For one, capital gains probably won’t play as much of a role in chapter 7 because debtors’ incomes will likely be lower, leading to a lower capital-gains tax rates. Second, debtors still benefit from the rule in the tax code that excludes up to $250,000 (double for married couples) of appreciated value in a primary residence, so long as the debtor has lived in it for at least five years.
Third, the Bankruptcy Code exempts chapter 11 debtors from state “stamp taxes,” which includes state and city transfer taxes so long as the sale occurs pursuant to a confirmed plan. The state’s transfer tax is small, about 0.4 percent, but the New York City’s transfer tax can run between 1 and 2.625 percent, depending on the type of property sold and its sale price. Because these are exempted, debtors in chapter 11 New York bankruptcy can save hundreds of thousands of dollars that they would otherwise pay in taxes when selling assets. Moreover, chapter 7 debtors do not pay the state transfer tax after asset sales either. Here’s the New York case that defined stamp taxes in the Bankruptcy Code and specified that capital gains are not excluded.
Capital gains taxes and other taxes can surprise debtors, so it’s important to plan your case with an experienced New York bankruptcy lawyer.
For answers to more questions about bankruptcy, the automatic stay, effective strategies for dealing with foreclosure, and protecting your assets in bankruptcy please feel free to contact experienced bankruptcy attorney New York Bruce Weiner for a free initial consultation.
