Underwater Properties and 1031 Exchanges

Everyone knows a Section 1031 exchange will allow you to defer the federal gain as well as the depreciation recapture on the sale and subsequent purchase of property held for investment or business use. Depending on the state, you may also be able to defer the state gain. Generally, to maximize the deferral, you must acquire replacement property of equal or greater value and equity but what happens if the relinquished property is underwater? Can you exchange if there is no equity?

1031 CORP. has long facilitated exchange transactions that involved no equity and some even required the Exchanger to bring funds to closing. Some would ask why you might want to do this. Unfortunately, the equity or net cash after mortgage payoff has nothing to do with the gain on a property. The gain is calculated by subtracting the net selling price from the original purchase price including closing costs and capital improvements. The equity is the difference between the fair market value of the property and how much money you owe your mortgage lender.

In recent years, many property owners have found themselves underwater; meaning the value of their property is less than the amount owed to the lender. This could have happened because the property was acquired or refinanced while the real estate market was at its peak in the mid-2000s and the property value has since decreased. For those that refinanced, they could still have a substantial gain on the property if it was owned for a number of years and especially if the Taxpayer 1031 exchanged into the property because there is deferred gain. There could also be quite a bit of tax due on the depreciation recapture even if there is a loss in property value. 

Questions have come up regarding the value and equity needed in the replacement property to defer all the gain in a short sale or foreclosure. Should the value of the replacement property be equal or greater than the current value of the relinquished property or the remaining balance on its mortgage?

In recent Private Letter Ruling 201302009, one taxpayer recently sought guidance from IRS on whether or not he could utilize a 1031 exchange to defer the gain. While this PLR can only be relied upon by this particular taxpayer, letter rulings are insightful for other taxpayers and their advisors dealing with a similar situation. Here is a brief summary of the facts involved:

    • Taxpayer was sole member of a single member limited liability company (LLC) which was a disregarded entity for tax purposes;
    • Relinquished property was encumbered by a non-resource liability;
    • Taxpayer owed more than the current fair market value of the property to the lender;
    • Taxpayer and lender would enter into a Transfer Agreement  and Taxpayer would agree to transfer the relinquished property to the lender subject to the debt;
    • Prior to transferring the property to the lender, Taxpayer would enter into an Exchange Agreement with  a Qualified Intermediary (QI) in order to effectuate a 1031 exchange;
    • Taxpayer would assign its rights in the Transfer Agreement to the QI;
    • Taxpayer would then enter into an Agreement of Sale for replacement property which would be assigned to the QI;
    • QI would then acquire the replacement property with cash provided by the Taxpayer or from debt and transfer the property to the Taxpayer; and
    • Taxpayer indicated the fair market value of the replacement property would be approximately the same as the outstanding debt on the relinquished property.

The IRS ruled the transaction as outlined would qualify for tax-deferral treatment under Section 1031.

This letter ruling would caution anyone in a similar situation to acquire replacement property equal or greater in value to the outstanding mortgage principal in order to maximize the deferral of gain and/or depreciation recapture. Of course, every situation is different and Taxpayers should consult their tax advisor for what is best in their particular situation but Section 1031 may be very beneficial.