Accelerating losses with an assignment for the benefit of creditors.

• Author: Wells, Thomas O.

When a flow-through entity for federal income tax purposes (such as a partnership or Subchapter S corporation) has losses, such losses are allocable to the entity's owners. If the owners have sufficient tax basis in their equity to utilize such losses and such losses are not otherwise limited by at-risk or passive activity loss rules, owners typically desire to accelerate the recognition of such losses because such losses may be able to reduce their income taxes for the year in which such losses, are recognized or may generate a tax refund by being carried back to the two prior tax years under [section] 172(b)(1)(A) of the Internal Revenue Code of 1986, as amended. (1)

For developers and home builders, many of these losses are attributable to the economic downturn and financial troubles that commenced in 2006 and 2007. This article examines the impact of the differences in the timing of loss recognition events by a developer seeking to sell or otherwise transfer real estate assets, file bankruptcy or commence an assignment for the benefit of creditors (an ABC proceeding) or that is subject to a foreclosure action, and how an ABC proceeding may be modified to constitute an abandonment loss and accelerate the timing of the loss recognition event.

Income Tax Treatment for Developers

A developer is prohibited from depreciating real estate assets and must capitalize expenses with respect to such assets pursuant to I.R.C. [section] 263A(b)(2). The requirement by a developer to capitalize expenses results in a deferral of any deduction or loss to the developer until such real estate assets are transferred. Such real estate assets are considered as inventory and subject to ordinary income or loss when sold. If the fair market value of such real estate assets has decreased below the developer's adjusted tax basis, the sale or transfer of such assets will generally trigger an ordinary loss to the developer. If the developer has generated taxable income in the prior two tax years, such loss could be carried back on an amended tax return and would generate an income tax refund for the developer.

Timing of the Recognition of Loss Due to a Sale, Bankruptcy, or Foreclosure

The recognition of a loss resulting from a sale or other transfer occurs upon the closing of the event under I.R.C. [section] 1001. However, the real estate closing event can be delayed due to many factors, including a lack of potential purchasers, unstable market conditions with declining real estate values, issues with a financial institution that may be funding a portion of the purchase price and due diligence, which could include an environmental audit and an appraisal if the purchase price is being financed by a financial institution. This delay results in a delay in the recognition of a loss. If the delay causes the sale to occur in a subsequent tax year, then the developer will lose the opportunity to carry back the loss to an earlier tax year that could have resulted in a larger tax refund.

The commencement of a bankruptcy does not create a loss recognition event for the developer pursuant to I.R.C. [section] 1398. (2) The developer is treated as continuing to own the assets contributed to the bankruptcy estate until the estate disposes of such assets. Accordingly, there is no recognition of a loss until such disposition occurs as is similar for a transfer occurring due to a sale or exchange of property. Although the bankruptcy sales process may be more accelerated than the typical nonbankruptcy sales process, it may still be delayed due to the appointment of a bankruptcy trustee, the marketing of real estate assets by the trustee, and the negotiations of a purchase and sale agreement by the trustee with an initial buyer followed by a bankruptcy auction of the real estate assets pursuant to 11 U.S.C. [section] 363. This process can take between six to 12 months. If the [section] 363 sale occurs in a subsequent year, then the developer will lose the opportunity to carry back the loss to an earlier year that could have resulted in a larger tax refund.

The recognition of a loss resulting from a transfer due to a foreclosure sale occurs upon the closing of such foreclosure sale under I.R.C. [section] 1001. The developer has discharge of indebtedness income under I.R.C. [section] 61(a)(12) equal to the difference between the debt being discharged and the fair market value of the real estate. The developer has an ordinary loss equal to the difference between the developer's adjusted tax basis in the real estate and the fair...