Bankruptcy: Not Just a Spot on a Popular Game Show’s Wheel
Real Estate/Construction Advisor, Spring 2008 Issue
The headlines read, “Neumann Homes, Inc., one of the largest privately held homebuilders in the Midwest and Denver, files for Chapter 11 bankruptcy protection” or “Lennar signs $525 million agreement with Morgan Stanley at a 40 percent discount” or “Pulte Homes to exit Kansas City” or “Toll Brothers reports its first quarterly loss.” Given the condition of the real estate and construction industry, and with little change expected on the near horizon, headlines like these are becoming all too common.
Homebuilding companies are getting creative in their approaches to meeting the challenging conditions required to weather the current storm in the real estate and construction industry. Strategies include reducing operating costs, selling inventory at a discount to match the accounting loss with the tax loss, and restructuring debt with lenders. Most homebuilders are selling off their land inventories to pay down debt and save cash. Many are exiting once-thriving geographical markets, and others are rethinking their approaches to holding land, instead opting for a more just-in-time focus. Sadly, many are left with limited alternatives, ultimately seeking debt relief by filing for bankruptcy protection, or restructuring debt through non-judicial restructuring efforts. This article deals with the relief provisions available to the debt discharge income of taxpayers who have filed bankruptcy or insolvent taxpayers taking advantage of a less costly non-judicial restructure alternative.
Section 108 of the Internal Revenue Code addresses the treatment of the income that results from the discharge of indebtedness. The premise that income should result from debt discharge manifests itself in the idea that indebtedness leads to an increase in wealth. The initial inflow of funds from the debt was not income at the time received because there was an obligation to repay the debt. Now, when the obligation to repay is removed, income should result. One must now review Section 108 to determine if that debt discharge can be excluded from income. This code provision allows bankrupt or insolvent taxpayers to exclude debt discharge from income. This relief, however, does not come free of charge. The taxpayer must reduce tax attributes or he/she may elect to first reduce the basis of depreciable property.
For tax purposes, bankrupt means the taxpayer’s discharge of debt has occurred under the jurisdiction of a court in a Title 11 case. Title 11 includes Chapter 7 (liquidation), Chapter 11 (reorganization) and Chapter 13 (small business) bankruptcies. Insolvency is defined as the excess of the taxpayer’s liabilities over the fair market value of the taxpayer’s assets immediately before the debt discharge. Tax attributes are deferred tax benefits; i.e., net operating loss carryovers, capital loss carryovers, passive activity carryovers, tax credits and basis of assets. Depending on the entity structure, insolvency may be determined at the individual level as opposed to the entity level.
If you are able to exclude discharge of indebtedness income because you are bankrupt or insolvent, you must reduce your tax attributes in the following order, dollar for dollar, except for the credits:
- Net Operating Loss Carryovers
- General Business Credits
- Minimum Tax Credit
- Capital Loss Carryovers
- Basis of Depreciable and Nondepreciable Property
- Passive Activity Loss and Credit Carryovers
- Foreign Tax Credits
There is an election available where one could first choose to reduce the basis of depreciable property rather than other tax attributes. Further, it is important to mention that if the aggregate liabilities after the debt discharge exceed the aggregate tax basis of the taxpayer’s assets, then no reduction of the basis of those assets occurs. Thus, proper planning is required to know whether to elect to reduce the basis of depreciable property before other tax attributes, as some debt discharge could be excluded completely without impacting the basis.
Bankruptcy and events leading up to the discharge of debt can be difficult, but there are relief provisions in the Internal Revenue Code that can help to mitigate the tax consequences. Please contact our real estate tax team: Rick Barnvos at 847.628.8774, Dean Rocheleau at 248.223.3225, or Guy Ackermann at 312.602.3517 with any questions and for possible tax alternatives to your situation.
