A 1031 Exchange When You Have Negative Equity

As a result of the current real estate slowdown, we’re starting to see clients selling properties with negative equities.  By negative equity, I mean situations where they might owe more than the property is worth they can sell the property for.  Because of this, some interesting questions arise.  How does negative equity affect a persons ability to do a 1031 exchange?  Can you do an exchange when you owe more than the property is selling for?  Why bother if there is no cash, or if you have to bring cash to the table?

Most people (even many real estate professionals) tend to think of cash as the same as “gain.”  Therefore, according to their thinking, if you don’t receive any cash from a sale, you don’t have any gain.  And if you, as the seller, have to bring cash to the closing, you must have a loss, right?

Wrong!  In tax law, there is no correlation between “cash” and “taxable gain.”  Let’s take Fred and Sue as an example.  They bought their purple duplex for $25,000, put $5,000 of improvements into it, and have taken depreciation totaling $10,000 over the years.  Their tax basis in the duplex is $20,000 ($25,000, plus $5,000, minus $10,000).  If they sell it for $100,000, they will have a gain of $80,000, which will be taxable if they don’t do a 1031 exchange.  And keep in mind,  regardless of the amount of equity they have in the property, they have $80,000 of gain.

Let’s take this example a little further, last year the property was appraised at $125,000, and they were able to refinance it and get an 80% loan of $100,000.  Now, a year later, one of the tenants has moved out and caused significant damage in the process.  The duplex is 50% vacant and has tenant damage that needs repair.  Fred and Sue have an unsolicited offer of $90,000 for the property, as-is, and they want to take it.  Since there will be no cash (or equity) to them from the sale, should Fred and Sue even bother doing an exchange?  The answer is Yes!  We will explain why in the next article in this series.

Remember in our last article, Fred and Sue owned a purple duplex.  Over a year ago they refinanced it and took out $100,000 of cash based on their appraisal of $125,000.  The market has now turned they have lost their tenant who has done significant damage to the property.  They have an unsolicited “as-is” offer in hand for $90,000 and they want to accept it.  They come to you as their agent and want to know whether it makes sense to do a 1031 Exchange.

As you recall since Fred and Sue owned the property for so long, they will have a gain of $70,000.  Therefore, the answer is YES! – even though Fred and Sue will receive no cash from the sale, they still have a gain of $70,000 in this property.  Without a 1031 exchange, they will owe approximately $15,000 in federal and state taxes. 

There are some things they need to be careful of however, when they do the exchange.  The first is that they still need to retain a Qualified Intermediary to prepare exchange documents for them (for both the sale of their Old Property and the purchase of their New), even though there is no cash from the sale.  And second, even though they have no cash from the sale, they still need to buy equal-or-up, meaning that they will need to purchase a New Property for at least $90,000.

In summary – Fred and Sue will receive no cash from the sale of their property, and in fact, they will bring $10,000 to the closing.  Even worse, without a 1031 exchange, they will be out-of-pocket an additional $15,000 for taxes, plus closing costs!  Fred and Sue almost HAVE to do an exchange.  The taxes will make a bad situation even worse.  So, even when there is negative equity in a property, it often still makes sense to do a 1031 Exchange.