Just a few of the articles (from the full issue):
- “Potential Tax Consequences of Short Sales After the Expiration of the Mortgage Debt Relief Act May be Eliminated by Filing Bankruptcy” by Nedda Ghandi, Esq.
- “The Dirty Little Secret About Student Loan Debt in Bankruptcy” by Brian D. Shapiro, Esq.
- “Marijuana Dispensaries in Reorganization: A Little More Faith for a Growing Industry” by Yanxiong (Michael) Li, Esq.
- “Bankruptcy, Stress, and a Reality Check” by Zachariah Larson, Esq.
- “Chapter 11 Primer” by Candace Carlyon, Esq. and Matthew Carlyon, Esq.
© 2015 The following articles were originally published in the printed magazine COMMUNIQUÉ, the official publication of the Clark County Bar Association. (March 2015, Vol. 36, No. 3). All rights reserved. For permission to reprint this article, contact the publisher Clark County Bar Association, Attn: COMMUNIQUÉ Editor-in-Chief, PO Box, Las Vegas, NV 89125. Phone: (702) 387-6011.
Potential Tax Consequences of Short Sales After the Expiration of the Mortgage Debt Relief Act May be Eliminated by Filing Bankruptcy
By Nedda Ghandi, Esq.
In mid-December of 2014, the Mortgage Debt Relief Act of 2007 was extended at the eleventh hour to cover mortgage debt cancelled through the end of 2014. While Congress is expected to consider the further extension of this tax relief in 2015, the prudent homeowner should prepare for the possibility that another extension is not forthcoming.
Not all underwater homeowners are aware that along with the short sale’s lure of walking away from one’s home without owing a deficiency, comes the hidden tax implications of the cancelled debt. The financial implications of the short sale of a primary residence in 2015 must be considered in light of the expiration of the Mortgage Debt Relief Act, and the uncertainty of its extension.
Tax consequences of cancelled debt.
Cancelled debt is not always taxable. The federal tax code provides several exemptions and exceptions that allow certain cancelled debts to not be considered income for tax purposes. For example, any debts discharged in a bankruptcy are not considered taxable cancelled debts, even though the obligation to repay those debts is removed through the bankruptcy. Student loan debt that is cancelled because of the borrower’s service or work in designated public or government fields is another example. In these situations, no tax liability would arise for the borrower based upon the cancelled debt.
The tax code also provides an insolvency exception to reporting cancelled debt as income. If the taxpayer’s liabilities exceed his assets, the taxpayer may be considered insolvent and not incur income tax liabilities for cancelled debt that is less than his liabilities. For the purposes of this calculation, liabilities would include the total mortgage owed prior to the short sale. However, it is the taxpayer’s burden to prove the total amount of his assets and his liabilities.
Prior to the Mortgage Debt Relief Act of 2007, the amount of mortgage debt cancelled on a primary residence, such as through a foreclosure or short sale, was taxable at the normal income tax rate. The Mortgage Debt Relief Act of 2007 prevented homeowners from having to pay this tax on mortgage debt cancelled on their primary residence, but the future is uncertain for such mortgage debt cancelled after December 31, 2014.
Potential tax consequences of a short sale without renewal of the Mortgage Debt Relief Act.
When a short sale is approved, the lender typically cancels a large portion of the remaining mortgage debt owed by the borrower. This cancelled debt is generally treated as part of the borrower’s regular income for tax purposes. Lenders usually report this cancelled debt to the Internal Revenue Service on form 1099-C, Cancellation of Debt.
According to Realtytrac, 8,590 properties in Las Vegas were in some stage of foreclosure in December of 2014, an increase over the amount of such properties in November 2014. Thus, it appears that there will be many underwater homeowners who will go through a foreclosure or short sale this year while facing the uncertainty of whether their tens or even hundreds of thousands of dollars in cancelled mortgage debt will be taxed as regular income.
Without the exemption for cancelled debt on a primary residence, the underwater homeowner electing a short sale may be hit with a large tax bill. Take, for example, the purchase of a home in Las Vegas for $500,000 through a loan which gives the bank a purchase money security interest in the home. After the crash of the Las Vegas housing market, this home now has a fair market value of $250,000. If the bank agrees to sell the home through a short sale, typically the bank will agree to cancel the amount of the mortgage debt that remains unpaid by the homeowner, referred to as the deficiency.
A short sale is completed, and after the funds received from the buyer are applied to the outstanding mortgage balance, the homeowner still owes $150,000. The bank has agreed not to go after the homeowner to recover that deficiency, but the bank would issue a 1099-C to the borrower and report the cancelled debt to the IRS. Thus, the borrower would incur ordinary income tax liability on that $150,000 of cancelled debt. At an effective tax rate of 25%, this “income” would generate a tax bill for the borrower of about $37,500.
As of 2007, cancellation of debt on a primary residence was excluded from being treated as taxable income through the Mortgage Debt Relief Act. However, as it now stands, the Act has expired and if it is not extended, any mortgage debt that is cancelled on a primary residence on or after January 1, 2015 will be taxable as ordinary income. Whether or not the Act will be extended is not certain, and may not be known until the end of this year.
Filing bankruptcy prior to tax event occurring to avoid adverse tax liability.
Income tax debts are dischargeable through a bankruptcy, but not right away. The general three-part rule for discharging income tax debts in a bankruptcy is that the income tax return must have been due at least three years prior to filing bankruptcy, the income tax return must have been filed at least two years prior to filing bankruptcy, and the income tax must have been assessed by the IRS at least 240 days prior to filing bankruptcy. Thus, at the very earliest, a tax obligation based upon debt cancelled in 2015 would not be dischargeable in a bankruptcy until April 15th, 2019. However, the timely filing of bankruptcy can prevent the income tax debt from arising in the first place.
Due to the uncertainty of whether or not the Mortgage Debt Relief Act will be extended to include mortgage debt cancelled in 2015, the underwater homeowner electing a short sale wherein a significant amount of mortgage debt will be cancelled may want to consider filing for bankruptcy prior to the tax event occurring. Ordinarily, the tax event would occur when the cancelled debt is reported to the IRS by the lender. However, no tax liability arises for the bankrupt debtor when his debts are cancelled in the bankruptcy. Any tax liability that would potentially arise outside of bankruptcy based upon the cancelled debt would not arise while in bankruptcy.
Therefore, the underwater homeowner pursuing a short sale may benefit from filing for bankruptcy very soon after the short sale closes. This would prevent the homeowner from incurring a substantial income tax liability on the cancelled debt whether or not the Mortgage Debt Relief Act is extended.
Based upon the uncertainty surrounding another extension of the Mortgage Debt Relief Act, attorneys should advise upside-down homeowners pursuing a short sale to consider the potential large tax liability that may arise. The expiration in 2014 of the cancelled debt exclusion for primary residences means that the homeowner may want to consider filing for bankruptcy prior to the cancelled debt being reported in order to avoid significant tax consequences of the short sale.
Nedda Ghandi, Esq. is a founding partner of Ghandi Deeter Law Offices, where she focuses her practice on bankruptcy and family law. Her bankruptcy practice emphasizes both consumer debt and business debt relief. She is also admitted to the United States Tax Court and often deals with client dilemmas similar to those discussed in this article.
The Dirty Little Secret About Student Loan Debt in Bankruptcy
By Brian D. Shapiro, Esq.
Student loans may be dischargeable in bankruptcy by the filing of an adversary proceeding in the debtor’s bankruptcy case. In 2014, only a few student loan cases were filed in Nevada. Why not more?
The dirty little secret is that most bankruptcy attorneys exclude the filing of adversary proceedings in their retention documents. The main reasons for the exclusion is because there is not a large profit margin in prosecuting student loan cases, the attorney’s lack of knowledge, and it is time consuming.
The 9th Circuit test to determine if a student loan may be discharged is known as the Brunner test. In re Pena, 155 F.3d 1108 (9th Cir. 1998) (adopting the Brunner test as stated in In re Brunner, 46 B.R. 752, 753 (S.D.N.Y. 1985) (Aff’d by 831 F.2d 395 (2nd Cir. 1987)). In order to discharge a student loan, a debtor must meet the following factors: (1) cannot maintain a minimal standard of living; (2) the situation will continue; and (3) the debtor made a good faith effort to repay.
Despite this stringent standard, the 9th Circuit recently applied a liberal approach and discharged $55,000 of an $85,000 loan. (In re Hedlund, 718 F. 3d. 848 (9th Cir. 2013).) In Hedlund, an Oregon law school graduate had $85,000 in student loans but did not pass the bar exam. He obtained full employment as a counselor. He negotiated with his lender but the lender wanted $10,000 up front, then $1,300 a month or a lump sum of $80,000. As the debtor had limited funds, he offered to make a $5,000 payment in exchange for lenient payment terms. The lender declined. For about a year, the lender garnished his paycheck and as a result the debtor filed bankruptcy and attempted to discharge his loans. The bankruptcy court granted a partial discharge, but the lender, who did not like the adverse decision, appealed to the United States District Court of Oregon who reinstated the student loans (based upon his lack of good faith in attempting to repay the loans). The 9th Circuit reversed and found that the bankruptcy court was correct in determining that the debtor’s attempt to repay his loans was done in good faith and reinstated the partial discharge. The moral of the story is that it is possible for an individual to get relief from a student loan.
As most bankruptcy attorneys do not handle such an action, it is important to recommend a bankruptcy attorney who is willing to handle the case on a flat fee, has a good reputation in the bankruptcy community, and is willing to try to negotiate a reasonable resolution. Student loan companies do not want an adverse decision and will appeal such a decision. Importantly, they are willing to try to resolve a case prior to trial.
Brian D. Shapiro is the Managing Member of the Law Office of Brian D. Shapiro and is a Nevada Bankruptcy Trustee. He has represented individuals and Student Loan Companies.
Marijuana Dispensaries in Reorganization: A Little More Faith for a Growing Industry
By Yanxiong (Michael) Li, Esq.
Medical marijuana dispensaries sell goods, compete for customers, buy or rent property, pay utility bills, hire employees, borrow from creditors, etc., and are subject to the same forces that render other businesses susceptible to financial distress. Unlike your neighborhood grocer, however, bankruptcy relief may not be as accessible for struggling dispensaries due to their uncertain status of legality as to operations. Federal prohibition on sale, growth, and distribution of marijuana has been established since 1970 through the Controlled Substances Act (“CSA”). But it was not until 2005 that the Supreme Court of the United States confirmed Congress’ power to regulate noncommercial, purely intrastate production and use of marijuana for medical purposes. 21 U.S.C. § 801 et seq; Gonzales v. Raich, 545 U.S. 1, 18 (2005). As of 2014, 24 states, including Nevada, have enacted state or local laws permitting medicinal marijuana use, following in the footsteps of California’s Compassionate Use Act of 1996. Cal. Health & Safety Code § 11362.5; compare NRS 453A, et seq. Most such state laws appear directly in conflict with the CSA and some even permit access to medical marijuana via home cultivation.
The Bankruptcy Code does not explicitly prohibit dispensaries seeking reorganization relief, but this has not deterred trustees and creditors from successfully derailing several filings by relying upon the flexible “cause” and “good faith” standards under sections 1112(b) and 1129(a)(3) of the Bankruptcy Code. See, e.g., In re Rent-Rite Super Kegs West Ltd., 484 B.R. 799, 807-10 (Bankr. Colo. Dec. 19, 2012). The two-fold argument holds that federal prohibition of medical marijuana businesses provide sufficient “cause” for dismissal under 11 U.S.C. § 1112(b), and the nature of such businesses are “forbidden by law.”
Under section 1112(b), any party in interest may request dismissal of the case upon showing of “cause.” The flexible standard is intended to help preserve the debtor’s going-concern value, which, in most cases, outweighs its piecemeal liquidation price. “Cause” is not specifically defined under the code except by a non-exclusive list of examples under section 1112(b)(4). Although good faith is nowhere to be found in this list, courts generally accept this as an independent basis for dismissal under section 1112(b). In re Marshall, 721 F.3d 1032, 1047 (9th Cir. 2013).
The fundamental test of good faith ensures that the debtor ultimately intends to satisfy its debts, rather than merely to deter or harass creditors. Circuits are, however, split over the Fourth Circuit’s subjective bad faith plus objective futility test and the Eleventh Circuit’s approach, which does not inquire into whether a debtor has any realistic means of successfully reorganizing. See Kathleen Mullins, Bad Faith Constitutes “Cause” For Dismissal of a Bankruptcy Case, Bankr. Case Blog, http://stjohns.abiworld.org/node/167. Notwithstanding, a trio of common fact patterns have developed over time representing bad faith filings: (1) reorganization cases where the debtor has only one asset, typically in the form of real estate; (2) cases in which bankruptcy protection is strategically used to invoke a certain right or power under the code; and (3) where use of bankruptcy is solely for the purpose of achieving tactical advantage in litigation.
Even if the debtor survives an early attack on its petition, another good faith hurdle awaits the debtor under section 1129(a)(3). Section 1129(a)(3) requires that the plan be proposed in good faith and not by any means forbidden by law. By the added clause alone, it is evident that section 1129(a)(3) imposes more stringent scrutiny than the section 1121(b) analysis. To further complicate matters, circuit courts also apply different analysis here. For instance, what “law” to consider when assessing a plan’s legality will depend on the particular jurisdiction. See, e.g., In re Alaska Fur Gallery, 457 B.R. 764, 766 (Bankr. D. Alaska 2011) (Alaska state law); Lockyer v. Mirant Corp., 398 F.3d 1098, 1104 (9th Cir. 2005) (federal antitrust laws); In re Bolton, 188 B.R. 913, 917 (Bankr.D.Vt.1995) (U.S Constitution; Thirteenth Amendment). More importantly, perhaps, there is disagreement over what is forbidden: the plan’s substance – i.e., whether activities proposed to satisfy the claims violate some law – or conduct and manifestations during the solicitation process. See In re Arenas, 514 B.R. 887, 893 (2014) (Bankr. Colo. Aug. 28, 2014) (considering issue in context of Chapter 7 case); see also Richard M. Cieri, Barbara J. Oyer & Dorothy J. Birnbryer, “The Long and Winding Road”: The Standards to Confirm a Plan of Reorganization Under Chapter 11 of the Bankruptcy Code (Part I), 3 J. Bankr. L. & Prac. 3, 39–40 (1993).
Although dispensary petitions have encountered significant resistance under this dual set of good-faith tests, the inherent flexibility of these standards provides ample room for future courts to afford reorganizational relief for the growing marijuana industry. Until the Supreme Court of the United States intervenes to resolve the conflicting opinions among the circuits, court dockets may continue to experience an influx of marijuana-related petitions seeking to test the boundaries of these standards. From a policy standpoint, opening the doors of bankruptcy courts to marijuana businesses is reasonable, especially because the federal government has gradually allowed states to override its prohibition on marijuana cultivation and use by relaxing enforcement efforts. If states are allowed to test the merits of their particular forms of legalization, then why exclude dispensaries from the opportunity to seek bankruptcy relief that other businesses already enjoy? In its purest form, bankruptcy law provides a forum in which nonbankruptcy, including state, originated rights and duties are enforced. As state legalization efforts progress, and state governments continue to benefit financially from medical marijuana businesses, there is no better time for bankruptcy courts to welcome filings from marijuana businesses.
Yanxiong (Michael) Li, Esq. practices law with Wolfe & Wyman, LLP. His practice spans all aspects of litigation involving mortgage banking disputes. Contact Michael at (702) 476-0100.
Bankruptcy, Stress, and a Reality Check
By Zachariah Larson, Esq.
Google the phrase “suicide and financial problems,” and get 66,000,000 results in 0.42 seconds. Some of those results will talk about the late comedy great, Robin Williams, and his suicide. Some even postulate that his death may have been because of perceived insurmountable financial issues. As a bankruptcy attorney, I have seen firsthand how people find financial issues of life to be overwhelming. As professionals, this is a stress we sometimes have but often do not talk about. Many of us are used to making a good living, but student loans, big mortgages, fancy cars, designer clothes, and raising children cost a lot of money. When life throws us a financial curve ball, some of us have a really hard time seeing a way out because we have already overburdened ourselves financially.
There is a way out. Start reassessing your priorities before a financial crisis hits.. Do you need cable? Do you need an iPhone for every child? Do you need the big mortgage? Take a step back from your life and ask yourself what brings you a smile; day in, day out. I don’t know about all of you, but I have never looked at my stucco and said, “Wow, that really makes me feel good.” Growing up in rural Iowa and Colorado, I was blessed with loving parents and friends, but not money. I had a great childhood and it was in a house that was sold for less than what my first car cost after becoming an attorney. The point I am trying to make is not that we should all live in a rundown farm house in order to save money, it is that we should all focus on what really matters in life. For me, it is God, my country, and family. That will probably offend a lot of people smarter than me, but I don’t care. It makes me happy. It also doesn’t cost a lot of money.
Robin Williams, if some of the articles are correct, did not learn this lesson. It is alleged he felt deeply disappointed that he was not as financially successful as he thought he should be at his age and could not stand taking jobs he did not want just to earn a paycheck. How many of us would have laughed less at him in Mork and Mindy if we knew he perceived himself to be broke? Is his art going to be tainted because he was not as wealthy as he wanted to be? Are your children not going to watch Aladdin now? I would sincerely hope all of these questions are answered with a resounding “No.” He was a great artist, actor, and comedian. He made a lot of people laugh and smile, and it was not because of the size of his bank accounts.
So, take a step back from the all too material world of law. If you are struggling with finances, ask yourself, “what is it that I really need?” Go talk to your father or mother, hug your kids, or get a drink with friends. Life is not about how much money you make, life is about those you love. If you are having financial issues, do not be afraid to seek help. At the end of the day, I would rather know you personally and could care less about your portfolio.
Zachariah Larson, Esq. primarily practices in the area of bankruptcy and currently is a member of National Association Counsel of Bankruptcy Attorneys. You can reach Zachariah Larson at 702-382-1170.
Chapter 11 Primer
By Candace Carlyon, Esq. and Matthew Carlyon, Esq.
InThe Chapter 11 process is intended to put the debtor on the road to financial health by reducing and reorganizing debt. Used by businesses, Chapter 11 reorganization is also available to individuals. Although cases vary as to complexity, size, and length, the following is an outline of the most common elements of Chapter 11.
Petition, Schedules, and Informational Requirements.
The case is initiated by filing a petition. Schedules and statements of financial affairs must be filed within fifteen days thereafter. The bankruptcy clerk’s office will generate a Notice of Commencement of the case, including information regarding the initial creditors’ meeting, and the deadline for filing claims.
At the initial creditors’ meeting, conducted by the office of the US Trustee (“UST”), creditors may question the debtor. The UST’s office will also question the debtor. The debtor is required to file monthly operating reports, which are due by the twentieth of the month for the preceding period. Creditors may also examine the debtor pursuant to Federal Rules of Bankruptcy Procedure 2004.
Debtor Protections and Duties.
The rights and obligations of the debtor in Chapter 11 are myriad, including:
- The automatic stay. Immediately upon filing bankruptcy, debtors are protected by the automatic stay under Bankruptcy Code §362. This prevents, or “stays” most actions against the debtor or its assets. Creditors who violate the automatic stay face sanctions from the court. Creditors may move the court to have the stay lifted. Cause for relief includes the danger of dissipation or depreciation of collateral to the extent that the secured claim is impaired, failure to make lease payments, or other good cause.
- Use, sale and lease of assets; protection of cash collateral (Bankruptcy Code § 363). The debtor generally continues to operate in the “ordinary course of business” without needing court approval to keep and use its assets. However, the debtor has a fiduciary duty to maintain the assets for the benefit of the bankruptcy estate. The debtor must obtain court approval for transactions outside the ordinary course of business, including payment of unsecured debts incurred before the bankruptcy. The bankruptcy court may grant motions to continue to pay unsecured “critical vendors,” where essential to the debtor’s existence. Secured creditors are entitled to adequate protection in exchange for the debtor’s use of their collateral. Where security interests extend to cash the debtor has the obligation to segregate and not use such cash without permission of either the secured creditor or the court.
- Pending contracts. For any contracts on which performance is still owed on both sides, Bankruptcy Code §365 governs assumption or rejection of the contracts. In order to assume (and, if so desired, assign) such contracts, the debtor must provide assurance of cure of outstanding defaults and of ability to perform in the future.
- Litigation. The automatic stay pauses litigation pending in other courts. Litigation may occur within the bankruptcy via “adversary proceedings.” An adversary proceeding is initiated by the filing of a complaint. Cases pending at the time of the bankruptcy may be removed to bankruptcy court. There are specific rights that the debtor may enforce via adversary proceedings, including recovery of certain payments made shortly before the bankruptcy, and recovery of transfers made without receiving reasonably equivalent value. Occasionally, because the debtor made transfers to related people or entities or other “insiders” prior to bankruptcy, creditors may petition the court for permission to file a “derivative action” to recover those transfers into the bankruptcy estate.
- Loans. The debtor cannot require the extension of post-petition credit, and must generally apply to the bankruptcy court for permission to obtain post-petition loans.
- Appointment of trustee or examiner, or conversion or dismissal of the case. For cause the court may order the appointment of a trustee in a Chapter 11, or an examiner to investigate and report upon specific issues. For cause the court may order conversion of the case to a Chapter 7 liquidation, or may dismiss the case.
The Plan Process
The goal of Chapter 11 is reorganization of debt via a plan. First, the debtor must file a disclosure statement, which contains sufficient information about the debtor’s finances to enable creditors to decide how to vote on the plan. The court holds a disclosure statement hearing and sets deadlines for objecting to and voting on the plan.
Requirements for confirmation of a plan include:
- That the plan provide for classes of creditors, with voting tabulated by class. Unless a claim is “unimpaired,” meaning that all defaults are cured and all payments made when due under non-bankruptcy law, a vote may be cast for each claim. Generally, each secured claim is in its own class, and unsecured claims are generally placed in the same class (although the code specifically permits a separate “convenience class” claims intended for smaller claims to receive quicker and/or higher payment to avoid the administrative burden of extended payment of small amounts). Issues may arise from attempts to gerrymander voting via classification of claims.
- The plan must be accepted by at least one impaired class. Acceptance is achieved by obtaining yes votes from creditors holding at least two-thirds in amount and more than one-half in number of claims casting ballots in that class.
Dissenting creditors must receive at least as much as they would in a Chapter 7 liquidation.
- Dissenting secured creditors must receive the value of their interest, plus interest at a fair market rate.
- Unless all impaired classes accept the plan, equity must go to the creditors unless it is purchased in exchange for new money.
The plan must be feasible—the debtor has the burden of showing that it has a reasonable chance of success in completing the plan payments.
If the court confirms the plan, a confirmation order is then entered. The plan is generally “effective” after the 14-day appeal period has expired. However, the plan may provide for a delayed effective date, sometimes conditioning the effective date on certain future events, such as a sale or loan closing.
Upon the effective date, the plan becomes the new contract between the debtor and its creditors. If the debtor defaults, the plan may provide for enforcement or requests for relief to be addressed to the bankruptcy court, but generally any post-confirmation defaults can be addressed via non-bankruptcy enforcement proceedings.
These are the very basics of the Chapter 11 process. While it is impossible to break down all the complexities of the bankruptcy code into an article of this size, the most important thing to know is that if you or your client are involved in a Chapter 11, or are contemplating such a filing, that you should consult with a bankruptcy attorney with Chapter 11 experience.
Candace Carlyon, Carlyon Law Group. Ms. Carlyon has over thirty years’ experience in the Chapter 11 arena, including representation of debtors, secured creditors, committees, trustees, and equity holders.
Matthew Carlyon, Carlyon Law Group. Mr. Carlyon’s practice includes bankruptcy and civil litigation. He is a 2012 graduate of Boyd Law School and former extern to Nevada bankruptcy judges Gregg Zive and Bruce Beesley.