THE 1031 EXCHANGE INSTITUTE

Forced Sale of Taxpayer Real Estate

I have been hearing this question every where ever I go today.  Taxpayers are either selling their real properties through Short-Sale transactions or they are losing their real estate to lenders who are taking the taxpayers' real properties through foreclosure proceedings or via deed-in-lieu of foreclosures. 

I refer to these transactions as forced sales.  The taxpayers are forced to sell their properties because they can not continue to service the debt.  They are not choosing to sell them, rather they have no choice but to sell them.

Taxpayers are stunned to discover that they may actually have a taxable gain to pay taxes on even when they are essentially being forced to sell or lose their properties when they have NO EQUITY in the property. 

Equity versus Taxable Gain

They either do not know or forget that EQUITY and TAXABLE GAIN have nothing in common.  They are not even related concepts. 

Equity is the amount of net proceeds left over after the taxpayer has sold their real property and paid all of their costs and debt involved with the property.  It's the amount that they can walk away with after the sale has closed.  However, when the property value has fallen below what they owe on the property, they no longer have any equity. 

Taxable gain is the gross sales price less closing costs, less capital improvements made to the property during their ownership of the property, and less the original amount paid for the property.  This amount can still be a pretty scary number of the taxpayer has owned the property for a number of years. 

The Culprit: Pulling Cash Out by Refinancing

The taxpayer acquires real estate.  The real estate grows in value.  They refinance every year or so to pull out the increased equity.  They don't realy think about this, but they are pulling their taxable gain out of the property without paying taxes on it.

The property keeps going up, and they keep refinancing and pulling taxable gain out of it.  The taxable gain is essentially deferred until they sell the property.  It will be deferred indefinitely if they choose to 1031 Exchange into another replacement property, or it will be taxable if they choose to sell and cash out. 

Unfortunately, they do not have a choice in markets like this.  They can not keep the properties due to the difficulty in servicing the debt load, and they are therefore "forced" to sell their property either through a fire sale, short sale, deed-in-lieu of foreclosure or foreclosure. 

The problem: their equity is gone, but their taxable gain is not.  This is referred to as mortgage over basis.  The amount of debt ("mortgage") is greater than the cost basis of their property.  They owe more than what they paid for the property because they have been pulling their taxable gain out of the property over a period of time. 

Are there options?  Yes, in some cases.  There is relief for primary residences, but not for investment property.  So, taxpayers should consult with their tax advisors before selling or losing their real property to determine exactly where they are at in terms of potential taxable gain. 

Zero Equity 1031 Exchange

Investment property will often have a taxable gain left in the property if the investor has owned the property for a longer period of time.  The forced sale of the property will result in the triggering of the taxable gain.  They have few options to consider, but the Zero Equity 1031 Exchange might be a solution.  It will require hard work and creative thinking as well as a creative team of experts, including a creative real estate agent or broker to help find the right replacement property.