Income tax update for homebuilders

Implications: What are the econonmic and cash impacts from a tax standpoint of large impairment losses recorded by homebuilders?  How/when can cash be recovered from these losses?

Analysis: A number of recent questions about homebuilding concern the ability of homebuilders to recognize cash from operating losses that are carried back on prior years" tax returns.  While not an exhaustive discussion, this is a quick overview to issues associated with realizing cash from net operating losses.

Many homebuilders have recognized large losses for financial statement purposes and have established large deferred asset accounts associated with income tax benefits.  In some cases, homebuilders have recorded income tax receivable assets.  The recognition of a financial statement loss (most recently from inventory and other impairments), does not automatically mean there are income tax return losses.  Rather, impaired inventory must be disposed of to trigger a tax return loss.  If the impaired asset is land, this loss can be realized by either selling the raw land or by building a home on it and selling the completed unit.  Writeoffs of option contract values would trigger tax return loss realization as such action would consumate a transaction in that an option contract was cancelled or expired.  Goodwill and other intangible asset impairments normally would not be deductible currently and may only result in increased tax basis in an acquisition that can be amortized over time or realized only if the subsidiary is sold.

The reason for attempting to trigger losses for income tax return purposes is so such losses can be carried back two years and be used to recover income taxes paid.  This recovery comes in the form of a cash refund.  For many large homebuilders, substantial amounts of income taxes were paid that might be recovered, creating a potential infusion of much needed cash.  Lennar recently created such a transaction by selling impaired land in an effort at recovering previously paid income taxes via net opeating tax return loss carrybacks.  Any income tax return losses that are not able to be carried back to recover previously paid taxes are available to be carried forward up to 20 years to offset future taxabel income.

Some builders with large deferred tax assets (these would be created by losses recognized for financial statement purposes that are not currently deductible for income tax return purposes), may encounter issues with continued recognition of such large balances unless income tax return losses are triggered and carried back creating tax refunds.  When deferred tax asset recognition becomes in doubt, tax valuation reserves will be established and the effective tax benefit rate on the income statement will be reduced from the normal 35-40 percent rate.  Thus, it is important to read the income tax footnote in the financial statements for an explanation of the effective tax rate and whether there are valuation reserves for financial statement tax benefits.  Hovnanian is a recent example of a someone that established tax valuation reserves.

In summary, many homebuilders will realize cash due to income tax return losses.  However, to do so, income tax return losses must be realized.  An inability to realize such income tax losses may result in limitations on a homebuilders' ability to recognize income tax benefits from financial statement losses.