How To Determine if You Need to 1031 Exchange Property Lost Thru Foreclosure or Short Sale

The real estate market continues to stumble through one of the most difficult cycles in its history.  Real property owners are faced with numerous hurdles and challenges when "surviving" a real estate market like this, including losing their real property, whether it be their primary residence or an investment property, through a fire sale, short sale, foreclosure action or deed-in-lieu of foreclosure transaction. 

More Than Emotions, Anxiety and Fear

Real estate owners who are losing their property will not only experience all sorts of emotions, anxiety and fear, they will also have a wide range of questions, concerns and problems to deal with.  Their concerns will range from losing equity in their property (if any), to what kind of income tax consequences they may be faced with, to how the transaction will affect their credit rating.  The loss of their real property may even affect their business operation if the subject property is used in their business. 

Income Tax Consequences

Perhaps the most frustrating of these issues is the potential income tax consequences that the real property owner may face.  Owners often incorrectly assume that if they are losing their property, especially property held for rental or investment, and have no equity in their real property that they also have no income tax consequences to be concerned about.  This may not be the case if the owner's deemed "sales price" is greater than their cost basis in the property. 

Refinancing Creates the Problem

Property owners are generally shocked when I discuss the potential for income tax consequences resulting from the loss of their real estate.  They have a difficult time getting their heads around the fact that they are selling or losing a property and receiving no cash or equity at the closing but will still owe capital gain taxes. 

The problem is that many owners have refinanced and pulled cash (equity or profit) out of their real properties during the last few years.  Some have even refinanced numerous times.  The cash they pull out of the property each time represents some or all of their equity or profit.  This means that they have pulled equity or profit out of their properties, but they have not paid any capital gain taxes yet. 

Seek Tax Advice

It is absolutely critical that property owners understand exactly what their income tax consequence will be for each specific transaction.  They need to have their tax advisor review any potential transaction, whether it be a straight sale, short sale, foreclosure action or deed-in-lieu of foreclosure transaction, before the transaction closes to ensure they avoid any painful surprises when they file their income tax returns the following year. 

Exclusions and Exemptions For Primary Residence, But Not Investment Property

There are a number of exclusions and exemptions for the disposition of an owner's primary residence, so losing a primary residence may not create any income tax challenges, but there is virtually nothing to save the real estate investor.  There are no exclusions or exemptions to speak of for investors to fall back on when they lose investment property, so careful planning is required once the investor has a handle on the income tax consequences.

Taxable Gain From Short Sale or Foreclosure

A taxable capital gain will result from a short sale, foreclosure action or deed-in-lieu of foreclosure transaction, if the investor's outstanding mortgage debt on their rental or investment property exceeds their adjusted cost basis in the property.

The transfer of the investment property through a short sale, Trustee's Sale (foreclosure action) or deed-in-lieu of foreclosure transaction is treated in part as if the investment property was sold.  The amount of capital gain that is recognized depends on whether the loan is recourse (e.g., the lender can go after the borrower) or nonrecourse (e.g., the lender can not go after the borrower).

The real estate investor is treated for income tax purposes as:

(i) having cancellation of indebtedness income or "debt forgiveness" to the extent that the outstanding loan amount exceeds the fair market value ("FMV") of the investment property, and a capital gain or loss equal to the difference between the actual fair market value of the investment property and the investor's adjusted cost basis for tax purposes when the debt is recourse to the investor; and,

(iii) in the case of a nonrecourse loan, the real estate investor would recognize a capital gain equal to the difference between the outstanding loan amount and the real estate investor’s adjusted cost basis in the investment property.

Proactive Income Tax Planning

Unfortunately, the income tax consequences of a short sale, foreclosure action or deed-in-lieu of foreclosure transaction are often reviewed only after the investment property has been lost and it is too late to do anything about the taxable gain. 

However, with proactive planning, the real estate investor can potentially defer the income tax consequences by structuring a Zero Equity 1031 Exchange™. 

Zero Equity 1031 Exchange

This income tax planning concept is relatively straight forward.  It involves structuring a 1031 Exchange transaction for the disposition of the investor's relinquished property even though it is being lost through a short sale, foreclosure action or deed-in-lieu of foreclosure transaction.  The only difference between this and a regular 1031 Exchange is that the Qualified Intermediary will not be holding any cash (equity) since there is no equity left in the property. 

The cash that would otherwise be needed to pay the investor's capital gain taxes would be used to acquire like kind replacement property through the Zero Equity 1031 Exchange.  It gives the struggling real estate investor options that they may not have had otherwise.  This tax planning tool does require outside-the-box thinking and creative acquisitions since there is no equity (cash) to be used to acquire the replacement property, and some transactions may require the Qualified Intermediary to acquire and then convey title to the investor's relinquished property.