1031 Exchange Foreclosure: How to Defer Taxes on Distressed Properties

A 1031 exchange foreclosure can complicate the execution of a like-kind exchange, but understanding your options could prevent a significant tax burden and open up possibilities for exchangers with distressed properties.

For owners of business and investment property, an IRC Section 1031 like-kind exchange can make it easier to acquire more valuable assets and build wealth over time. By deferring taxes on a property sale when using the proceeds to acquire like-kind property, taxpayers can reinvest more in future properties, allowing them to diversify, upgrade, and increase the value of their portfolios.

A 1031 exchange can be performed with a property that is owned outright or one that has a mortgage. It may be that an investment property you own was purchased with a loan that now has an outstanding amount greater than the value of the property. Even though you’ve built up significant equity, the property could be facing foreclosure, creating a potential 1031 exchange property in foreclosure scenario.

Although this is not an ideal situation, you do have options beyond simply walking away. With a 1031 exchange foreclosure approach, it could be possible to exchange your interest in the distressed property for a property with greater upside potential, preventing an immediate tax hit and helping you get the most out of your investment.

Foreclosure Tax Consequences: Cancellation of Debt Income and 1031 Exchange Solutions

A property is considered underwater if its outstanding debt exceeds its fair market value (FMV). In this case, the property owner has a few options. They could continue to make payments, with the hope that the property’s value will eventually increase enough to make the investment worth it. They could execute a short sale, where the property is sold for less than the outstanding loan amount; this would mean a loss of capital, but could be preferable to the third option, allowing the lender to foreclose on the property.

Even though foreclosure could involve a significant loss, it may still result in taxation. As explained by Baker McKenzie, “If the debt secured by the property is a nonrecourse liability, the taxpayer will recognize gain on a foreclosure to the extent that the taxpayer’s adjusted basis in the property is less than the outstanding principal amount of debt. If the debt is a recourse liability, however, the amount of recognized gain is limited by the FMV.”

The amount of debt in excess of the FMV is foregone in a foreclosure, and for tax purposes, “such excess is treated as cancellation of debt income (COD income).” The property owner would therefore owe taxes on this income.

But as the Baker McKenzie article explains, it is possible to defer this gain through a 1031 exchange:

Under Tufts, 461 U.S. 300, 51 AFTR2d 83-1132 (1983), the conveyance of property to the lender is a sale or exchange of the property, and Section 1031 does not require that the taxpayer have equity in the property—it only requires a sale or exchange. Furthermore, the IRS has taken the position that Section 1031 applies when property is sold at either a gain or a loss, implying that the key element to the application of Section 1031 is the sale or exchange and not the amount of the proceeds from the sale.

Short sales and foreclosures are never an ideal situation, but if the decision has already been made to pursue one of the two, the damage could be mitigated through a 1031 exchange short sale, exchanging into a new property, continuing tax deferral, and reinvesting in another asset.

Executing a 1031 Exchange Before Foreclosure: Timing, Title, and QI Requirements

There are many reasons why one might want to exchange out of a property that is facing foreclosure. For starters, the current property is clearly not working out, so pursuing another investment is likely the right move. If the property was acquired in a 1031 exchange, foreclosure would mean losing out on the tax deferral strategy already in motion. A heavy tax burden that same year could be disastrous if one acts without understanding the consequences.

A foreclosure exchange could allow the taxpayer to resurrect their 1031 strategy. We know that partial exchanges can be viable, so the property owner could use a partial exchange to downsize from a high-value property that is underwater to a lower-value property that is easier to manage. The leftover boot, once taxed, could be used to make mortgage payments on the new property. Cash that might otherwise go to tax payments could be added during the exchange to continue to build value rather than going to taxes on an already-failed investment. One could also exchange from a recourse loan to a non-recourse loan, or an actively-managed property to a passive investment like a triple-net lease or Delaware Statutory Trust (DST).

It’s important to understand that as the property owner, you must still hold title to the property to complete this type of exchange. That means you need to act prior to foreclosure. You will also need a parking arrangement set up the Qualified Intermediary (QI) prior to foreclosure. And you must navigate the mortgage process for the replacement property, which could make the exchange difficult to pull off, depending on the situation.

1031 Exchange Short Sale Strategy: Acquiring Distressed Replacement Properties

Just as it’s possible to discharge a distressed property as your relinquished property, it is also possible to acquire a distressed property 1031 exchange asset as your replacement property. Again, there could be issues with securing a mortgage, as banks could be reluctant to lend for the purchase of a property that has lost value, especially if it has been damaged.

If purchasing a property through a short sale, the 1031 timeline could be an issue. Under normal circumstances, the exchanger has 45 days from the closing date on the relinquished property sale to identify potential replacement properties and 180 days to complete the exchange. A short sale can’t occur until the lender accepts the purchase and sale agreement; if the bank does not approve the sale within the 180-day window or rejects the sale, the exchanger will have to rely on one of their other identified properties, or the exchange could fail.

Certain distressed properties could have a greater likelihood of securing financing for a 1031 exchange. For example, Baker McKenzie highlights zero cash flow properties: “Property that is subject to a triple net lease to a creditworthy tenant will sometimes be sold subject to a loan that consumes all of the cash flow from the property. Because of the secure nature of the cash flow, plus the fact that nothing is paid to the borrower until the debt is repaid in full, lenders frequently will lend a much higher percentage of the FMV of the property in such transactions.”

Another example is an improvement exchange. It’s possible to use exchange funds to make repairs on a property during the exchange and still defer all taxes. One could sell a high-value property, purchase a distressed property at a lower amount, and use the leftover exchange funds to improve the property before taking it over.

Given that it is possible to exchange out of or into a property facing foreclosure, it is also possible to exchange from a property facing foreclosure into another distressed property. This would mean navigating the particulars of each type of foreclosure exchange, something that could have major tax consequences if rules are misunderstood. To execute this type of exchange, you need to work with a third party that understands Section 1031 rules and how to execute an unusual exchange.

Qualified Intermediary Foreclosure Exchange: Essential Compliance Controls

For any 1031 exchange, you need a Qualified Intermediary to hold funds during the exchange. An exchange involving properties in foreclosure can be even more complex than a normal exchange because of the parking arrangements needed. To successfully execute this type of exchange, you can’t work with just anyone; you need an experienced Qualified Intermediary foreclosure exchange provider that understands these parking arrangements and how they can go wrong.

JTC’s team has decades of experience with all manner of exchanges, including reverse exchanges, construction exchanges, and those involving DSTs. We can work with you to develop the right strategy for your situation and put the necessary controls in place to ensure compliance so you can defer taxes and continue on your journey to building wealth.

Ready to Execute Your 1031 Exchange Foreclosure Strategy?

Contact JTC to speak with a specialist about your situation and the controls needed to complete a compliant exchange.

Choosing the right QI for your exchange