Foreclosures & Short Sale of 1031 Property?  Plan Ahead

1031 Properties Can Result in Tax Gain

Investors - Plan Ahead to Avoid a Loss

Unfortunately in this economy, some investors are faced with the prospect of a foreclosure or short sale. In this situation, individuals are naturally concerned about the many negative effects on their credit and the loss of the equity that they had invested in their property. Regrettably, there is often another consequence that often is not taken into consideration: the short sale or foreclosure can sometimes result in an income tax gain that must be recorded. This is especially true if the property was originally obtained in a §1031 Tax-Deferred Exchange.

In the context of a short sale or foreclosure, the income tax gain would come about if the mortgage debt is greater than the taxpayer's adjusted basis for income tax purposes. This happens because the transfer of the property to the lender is treated as if the property is sold to the lender for its fair market value.

The amount of gain recognized is determined based on whether or not the mortgage debt is recourse (a loan for which the borrower is personally liable) or nonrecourse (a loan for which the borrower is not personally liable). If the borrower secures a recourse loan, the investor is treated for income tax purposes as: (a) having termination of debt income to the extent that the mortgage debt is greater than the fair market value of the property and (b) a capital gain or loss equivalent to the variation between the actual value of the property and the taxpayer's adjusted basis for income tax purposes. In the case of a nonrecourse loan, the investor recognizes a gain equal to the difference between the mortgage debt and the investor's basis in the property.

Generally speaking, most taxpayers only consider the consequences of a short sale or foreclosure after the property has already been transferred. However, with a little forethought and planning, investors may be able to defer the income tax gain prior to losing the property. For example, the cash that would otherwise be needed to pay the tax liability could be used to acquire replacement property in a §1031 Tax-Deferred Exchange. For practical reasons, this option will not be available to all investors.

An example of how some taxpayers are using this approach in a fractional ownership foreclosure include acquiring a tenant-in-common (TIC) interest in commercial real property through a Tax-Deferred Exchange. The TIC interest is managed under a master lease where the investor receives a fraction of the net rent received by the master lessee on the property. The investor’s “exchange basis” in the TIC interest is $70. The TIC interest is originally obtained with a value of $200 and secures an interest only nonrecourse mortgage in the amount of $170. After three years, the TIC interest is worth only $160 and the loan has expired. As a consequence of the reduced value of the TIC Property, the TIC investors are unable to refinance the TIC Property and the lender will foreclose on the property. If nothing is done by the investor, they will have to recognize a tax gain on the foreclosure in the amount of $170-$70 = $100. The capital gain will result in a tax due in the amount of approximately $28.

In this case, the foreclosed property is treated as the surrendered property in the exchange and transferred to a “Parking Arrangement” right before the foreclosure takes place. The investor then can identify a Like-Kind property with a value equal to or greater than $170. The replacement property is acquired by using the $28 as a down payment and obtaining a loan for the balance of the $170 purchase price. The $28 would otherwise have been used to pay the capital gain tax liability incurred with the foreclosure. When the exchange is complete, the $100 gain will be deferred and the investor ends up with equity in another investment property rather than paying the tax.

Although many of these exchanges are fairly simple, there are some transactional challenges relating to the foreclosure process that must be overcome, not to mention issues relating to financing the replacement property. For this reason, any exchange structure must be planned well in advance of the actual foreclosure or short sale. It is critical that the investor consult with qualified legal and tax advisor regarding the planned exchange.  Contact us today if you're facing such a situation! 

Elaine Whitton Davis
Elaine Whitton Davis
1602 Ebenezer Road Rock Hill SC 29732