Deft Tax Move Makes Best of Bad Situation

Hovnanian's $216 million accounting charge is "textbook case" of using a value allowance, says one expert.
Stephen Taub and Marie LeoneDecember 20, 2007

Hovnanian Enterprises said on Tuesday that it was unsure of its ability to earn enough income to take advantage of tax deductions it had accumulated. The notice came in a regulatory filing in which the homebuilder disclosed that it would book a $216 million valuation allowance for the fourth quarter — a deft accounting move, according to Lehman Brothers tax expert Robert Willens.

He said the homebuilder took the charge in the same period that it generated net operating losses (NOLs), something not all companies choose to do. The charge was spurred by Hovnanian’s $638 million in such losses this year, compared to $139 million in net income. “This is a textbook case for creating a valuation allowance,” Willens told

He explained that valuation allowances stem from reported NOLs, which are created when expenses outstrip revenues in a given period. NOLs, in turn, allow companies to take tax deductions to offset future income — or a tax credit to apply against past tax payments. But to record one of these tax benefits, the deduction must meet the strict requirements of FAS 109, Accounting for Income Taxes.

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For example, under FAS 109, a company can garner a tax deduction if it’s more likely than not (management is more than 50 percent sure) that the company will have the ability to generate income during the carry-forward period when the losses will be netted. That means, if a corporation has reported recent losses, it becomes “virtually impossible” for management to be certain they can book the tax benefit, added Willens, who pointed out Hovnanian’s recent setback.

“I would have been surprised if they did not report a valuation allowance,” asserted Willens. He compared Hovnanian’s maneuver to General Motors’s latest valuation allowance. In November, the car maker recorded a $39 billion valuation allowance against its deferred tax assets. That charge included losses from prior periods because GM determined that the older NOLs were caused by one-time events, and therefore did not weaken its ability to generate income in the future.

Willens thinks homebuilders are particularly adept at handling tax issues because they manage a cyclical business. “They are savvy about managing their tax situation. They know their way around NOL rules,” he said. For instance, in a December client advisory, Willens reported that homebuilders use land swaps to generate tax deductions that are big enough to cover NOLs.

Such a swap would take place between two land owners that exchange tracts of land with similar physical characteristics and equivalent market values. A loss could be booked if a few IRS requirements are met. First, the land exchange must be deemed a “disposal” of property. Then, the values of the properties recorded have to be less than the adjusted basis of the property. If those two IRS criteria are met, a company is allowed to carry NOLs back to the two taxable years preceding the year when the loss is recognized. At that point, the company can claim a refund of all or a portion of the taxes it paid in those prior two years, wrote Willens.

NOLs can also be deferred for up to 20 years into the future. It’s the government’s way of granting tax relief when companies lose money, since corporations pay income tax immediately. With that kind of time horizon, Willens expects Hovnanian, and other companies that were hit hard by the credit crunch and sagging home market, to take advantage of their deferred tax assets as soon as income begins to creep up. In fact, he says there is always a silver lining to valuation allowance charges. “The bad news is that Hovnanian has to take the charge today, but the good news is that it has $216 million of income to record in the future,” said Willens.

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