How The 1031 Exchange Works With Short Sales, Auctions, And Foreclosures

Short Sales and 1031 Exchanges

You can acquire property in a short sale through a 1031 exchange; however, you may find it difficult to do so while complying with the exchange deadlines. Section 1031 of the Internal Revenue Code requires taxpayers to identify replacement property within a 45-day Identification Period and to close on the identified properties within the Exchange Period, which is a maximum of 180 days. In a short sale, a bid package must be sent to the asset manager at the bank. Included in this package is information regarding the seller’s financial situation as well as a settlement statement showing the amount of money the bank will receive on the payoff of their loan at the current bid price. The review of this package can (and regularly does) take up to 60 days. By this time, your Identification Period may have already expired leaving you unable to identify an alternate property for your 1031 exchange, or your Exchange Period may have expired. Please be aware of the time constraints and coordinate with your REALTOR® and your tax advisor before attempting this type of transaction.

Auctions and 1031 Exchanges

It is extremely difficult to purchase replacement property at an auction. When property is sold at an auction, there is no contract between the buyer and the seller. This is an issue because, when buying a property in a 1031 exchange, the taxpayer must assign its rights to buy the property under the contract to the qualified intermediary and the seller must be given notice of this assignment. Additionally, one of the fundamental requirements of a 1031 exchange is that the taxpayer cannot have control or “constructive receipt” of the exchange funds during the transaction. Many times, auction property is sold on the county courthouse steps or in a meeting hall where the seller is expecting the funds immediately after the auction. Because of the rules regarding constructive receipt, First American Exchange Company is unable to provide you with a check on the chance that you may purchase a property that day. Therefore, if you purchase a property through an auction, there must be time after the auction when First American Exchange Company can prepare the necessary exchange documents and coordinate the delivery of the exchange funds for the closing. In some instances, the seller will not delay the sale of the property to help facilitate a 1031 exchange. Speak with the seller or auctioneer of the property about this before you make any bids on auction properties.

Lack of a Contract from Auctions

When property is sold at auction and there is no contract between the seller and the buyer. This is an issue when attempting to exchange foreclosure property because, in order to have a valid exchange, the investor must assign his rights in the sale agreement to the Qualified Intermediary, and the buyer must be notified of that assignment.

An alternative to assigning the contract to the Qualified Intermediary is to have the Intermediary actually take title to the relinquished property before the foreclosure. There are legal issues which have to be addressed with this structure, but the arrangement is similar to reverse exchanges, where entities affiliated with Qualified Intermediaries also take title to property to facilitate the exchange.

Foreclosures and 1031 Exchanges

Most tax advisors agree that an investor can defer capital gains tax which is due upon foreclosure by exchanging the property in a 1031 exchange. These exchanges are uncommon, however, investors facing foreclosure should be aware of the potential to defer tax using a like-kind exchange.

You can acquire property in foreclosure through a 1031 exchange so long as there is a contract between the buyer and seller and there is a time period after the offer is accepted for First American Exchange Company to provide the exchange funds to close. Remember that the 45-day Identification Period still applies, so do your inspection of the property within the 45 days to make sure that the condition of the property is acceptable to you. If there are repairs that need to be made on the property after closing, you cannot fund these repairs through a standard delayed exchange. If the property needs substantial repair, a more complex structure known as an Improvement Exchange may be appropriate. Please speak with your tax advisor and First American Exchange Company before identifying or purchasing foreclosure property and ask about the Improvement Exchange process.

Lack of Cash with a Foreclosure

Internal Revenue Code Section 1031 does not require equity in order to complete a 1031 exchange; however, from a practical standpoint, the lack of cash is a huge issue for most investors. The investor will need to obtain financing and cash to fund the acquisition. In order to completely defer all tax, the replacement property will need to have a fair market value equal to or greater than the balance of the debt for the relinquished property. This can be accomplished with any combination of debt and equity.

Gain Upon Foreclosure

Most real estate loans are non-recourse; in other words, without any personal liability to the borrower. Upon foreclosure, the borrower loses all of his equity in the property, but is not at risk of losing his other assets in order to pay the debt. For example, if an investor owns property with a fair market value of $150 and a loan balance of $200, upon foreclosure the borrower loses the property but is not liable to the lender for the $50 shortfall.

For tax purposes, the foreclosure of property with non-recourse debt is considered a sale of the property for a value equal to the balance of the debt. In the case mentioned above, the foreclosure of the property would be considered a sale of the property with a sales price equal to $200. To compute the realized gain, you would subtract the basis of the property from this sales price. Particularly if the property was acquired as replacement property in an earlier exchange, the property basis could be quite low and because of that, there may be significant gain even if there is no equity.

The tax effect of a foreclosure where the debt is recourse is different. In addition, some investors may want to negotiate other solutions, such as a pre-foreclosure sale. We recommend that you call your tax advisor to discuss these issues, and call First American Exchange Company if you would like to set up a 1031 exchange or have any questions.