Not a single asset real estate debtor, or SARE, a condominium homeowners’ association falls under the definition of a small business debtor and is therefore permitted to reorganize under Subchapter V of chapter 11, for reasons explained by Bankruptcy Judge David M. Warren of Wilmington, N.C.

The condominium had three units. The homeowners’ association, or HOA, was responsible for maintaining, repairing and replacing the common areas. In his April 8 opinion, Judge Warren said that the debtor paid the common area’s expenses for electricity, phone, internet, fire alarm services, insurance, and the parking area, plus accounting and legal fees.

In addition to the common areas, the HOA owned a checking account and accounts receivable.

The HOA assesses the unit owners for the expenses that the HOA incurs.

To be eligible for Subchapter V, the debtor must be a “small business debtor” under Section 1182(1).

In Section 101(51D), the definition of a “small business debtor” excludes “a person whose primary activity is the business of owning single asset real estate.” Contending that the HOA was a SARE, the Bankruptcy Administrator objected to the debtor’s designation as a small business debtor under Subchapter V.

Judge Warren decided that the debtor carried the burden of establishing that it was not a SARE. The outcome, he said, was controlled by Section 101(51B)’s definition of “single asset real estate” to mean

real property constituting a single property or project, other than residential real property with fewer than 4 residential units, which generates substantially all of the gross income of a debtor . . . and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental thereto.

For Judge Warren, the only question was whether the common area “generates substantially all of the Debtor’s gross income.” The debtor contended that the common area “cannot be considered to be generating the Debtor’s income, because reimbursement for services generates the income of the Debtor.”

The Bankruptcy Administrator countered by contending that the debtor would have no income were it not for the common area.

Judge Warren decided that “the Debtor’s income derives not from the [the common area], but instead from the services the Debtor provides pursuant to its statutory obligations as a unit owners’ association.” In reaching this conclusion, he said it was “helpful to consider” whether the revenue was derived from entrepreneurial activity or was passively received as investment income.

Although the Debtor’s services are “arguably similar in nature to common area maintenance services provided under a lease,” Judge Warren said that “the revenues and expenses of the Debtor are not driven by the economic and financial return of the lease or sale of the related real estate condominiums.”

Judge Warren noted that the definition in Section 101(51B) uses the word “generates” to denote that the property itself must be responsible for income, and not a result from labor or management services.

Because the common area “does not generate the Debtor’s gross income,” Judge Warren held that the debtor “does not fit within the Code’s definition of SARE.”

Turning from the statute to policy, Judge Warren said that his holding “aligns with historical understand” of a SARE, which was intended by the 1994 Bankruptcy Reform Act to mean encumbered buildings attempting to avoid foreclosure by a major lender who was undersecured.

By way of contrast, the debtor had no consensual liens. On top of not falling within the meaning of a SARE “under the plain language of § 101(51B),” Judge Warren said that “the Debtor is not the type of debtor Congress was seeking to regulate when it enacted the Bankruptcy Reform Act of 1994.”

Judge Warren overruled the objection and allowed the debtor to proceed as a small business debtor under Subchapter V.

Observations

Occasionally, HOAs end up in bankruptcy. Because it’s not feasible for a condo or coop to operate without an HOA, a bankrupt HOA can’t liquidate but needs to reorganize in chapter 11.

The opinion by Judge Warren is good news for HOAs, because it means that they can more easily reorganize in Subchapter V.

Judge Warren’s opinion makes sense. A SARE owns the units and generates most of its income from renting the units, not the common areas.

An HOA, on the other hand, does not own the units and generates no income from the units. As Judge Warren found, an HOA generates income from assessments for managing the common areas and the affairs of the development.