Saved By A Short Sale/Foreclosure 1031 Exchange™
You are probably thinking to yourself "I've been saved by many things throughout my lifetime but never saved by a Short Sale/Foreclosure 1031 Exchange™, whatever that is." You are not alone, either. There are very few 1031 exchange Qualified Intermediaries, legal advisors, tax accountants or other professional advisors that even think about, let alone recommend, this 1031 exchange strategy to real estate investors that find themselves in trouble.
No Equity Left In Your Property
We see it in virtually every economic downturn. The real estate market drops significantly and real estate investors get caught between a rock and a hard spot. The market value of your investment property sinks well below the amount of debt that you owe on your property. Your equity in your real estate investments completely disappears. You begin to look for solutions, for a way to get out of this horrible nightmare that you find yourself in. You begin to think about other options such as short-sales, deeds-in-lieu of foreclosure, foreclosure, and filing for bankruptcy protection.
Beware: Taxable Gain May Still Exist
However, before you do any of these you must consult with your legal and tax advisors. The mere fact that your equity position has evaporated ("zero equity") does not mean that you have no taxable gain to worry about. In fact, it can be quite the opposite. You may still have depreciation recapture or capital gain taxes to worry about.
The short-sale for example is a sale of your real estate investment, and it will trigger any taxable gain that may still exist in the property. The foreclosure is a forced sale, and may also result in your taxable gain being recognized. It is extremely important to know and understand what you are up against before proceeding with any of these difficult choices.
It is also just as important to review potential solutions to combat any taxable gain that might be generated by these tough decisions. For example, hard as it might be to comprehend, you might still be able to structure what we have coined a Short Sale/Foreclosure 1031 Exchange.
Short Sale/Foreclosure 1031 Exchange
You can set-up and complete a 1031 exchange even on property with no equity. This allows you to defer the payment of your depreciation recapture and capital gain taxes into replacement property even though you have no equity. We coined the phrase a Short Sale/Foreclosure 1031 Exchange™.
Example Of A Short Sale/Foreclosure 1031 Exchange
You acquired commercial real estate back in early 2001 for $1,000,000. You paid for the property with a cash down payment of $200,000 and financed the balance of the purchase price by taking out an $800,000 commercial loan. This financing structure left you with a $200,000 equity position and $800,000 in outstanding debt as of 2001.
Now fast forward to early 2007. The value of your commercial real estate has shot up in value since 2001 so that your real property is now worth $3,000,000. Congratulations! You now have a $2,000,000 capital gain sitting in your commercial property!
You also took advantage of the significant increase in your equity by refinancing your commercial loan and pulling out the additional equity through a cash out provision every year or so. You now owe $2,700,000 on the property, which leaves you with $300,000 in equity. The cash equity that you have pulled out over the years has been similarly invested in other properties.
Fast forward again to late 2009. The real estate market has collapsed and property values are still dropping. Your commercial property is now estimated to be worth about $2,100,000 and is still dropping in value. You still owe $2,700,000 on it, which is about $600,000 more than what your property is estimated to be worth. You have lost a number of tenants and you now have a negative cash flow on the property.
You decide it is time to sell the property to mitigate your losses. You meet with your legal and tax advisors and your commercial broker to review your options, and you discover you have a very serious problem. You have no cash ("zero equity") available to make up the short fall ($600,000 plus closing costs), so you are going to have to try a short-sale and ask the lender to take less (short the payoff to the lender) in order to mitigate everyone's losses.
However, even though your property is worth much less than what you owe to the lender you still have a sizable taxable gain on the property. Remember, you paid $1,000,000 for the property back in 2001 and it is still worth about $2,100,000 in late 2009. You have a $1,100,000 taxable gain sitting in the property. You have taken this gain out of the property each time you have refinanced over the years, but you have not paid taxes on it yet. Selling the property under a short-sale will get you out of the property and the debt, but it will trigger your capital gain. You will probably also have some depreciation recapture to worry about. You feel trapped.
This is where the Short Sale/Foreclosure 1031 Exchange may be useful. You could proceed with your short-sale transaction, and set-up a 1031 exchange at the same time. Exeter 1031 Exchange Services, LLC would draft the 1031 exchange documents just like any other 1031 exchange transaction, and would be assigned into the purchase and sale agreement. The only difference with this 1031 exchange is that at the relinquished property closing or settlement there is no equity or cash that would normally be sent to Exeter 1031 Exchange Services, LLC as your Qualified Intermediary. It is a Short Sale/Foreclosure 1031 exchange.
The real challenge is finding a way to acquire replacement property when you do not have any cash equity in your 1031 exchange account to use as a down payment for the replacement property purchase. It is now time for a sophisticated, experienced and creative real estate broker that can help you negotiate and put together a creative acquisition package for replacement property. It is not easy, but you might be able to get out from under of your existing problem property, defer the payment of your taxes, and get into replacement property that puts you in a better position than what you had before.
It will not work for everyone, but it does give you some options to consider to help lessen the pain when you find yourself in this type of scenario.
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