Short Sales and 1031 Exchanges

It seems that every time I turn around, I hear the term “short sales” in connection with real estate. I hear talk of them in the locker room at the gym; I read about them in the newspaper, and I see them on the Six O’clock News. Since short sales are the big topic of conversation right now, naturally we’ve been getting a lot of calls from investors who want to know if they can, or should, do a 1031 exchange in a short sale situation.

Just so we’re all clear on what I’m talking about, a ‘short sale,’ as I use it here in connection with real estate, is ‘the sale of a property for less than what is owed to the bank.’

For example, let’s suppose Fred bought a rental house several years ago for $250,000. A couple of years ago, the property was appraised at $750,000. Fred refinanced the property and got a new loan for $600,000, paying off the existing loan and pocketing the difference of $350,000. The new loan was an adjustable rate mortgage with low interest rates and Fred enjoyed good cash flow on the property until recently. Then the loan rate adjusted upward significantly.

...Is there a way out of this problem? Of course! do a 1031 exchange!

Now, two or three years later, his loan payments have increased dramatically and the property has a significant negative cash flow. To make matters worse, Fred’s wife lost her job and they simply can’t continue to carry the property. They’ve tried to sell the rental, but the property currently has a true fair market value of around $500,000, which is less than the balance he owes on the loan. Fred doesn’t want to sell at this price because he would have to come to closing with a substantial amount of cash: the $100,000 shortfall in the loan balance, plus all the closing costs.

His Realtor has proposed that they could “short sell” the property to a buyer he’s found who’s willing to pay $475,000 for the property. What the Realtor means by ‘short selling’ the property, and what he’s proposing, is that Fred let the bank have the property back (in other words, foreclose), after which the Realtor can sell the property to his buyer, thereby shifting the loss from Fred to the bank.

So what does this mean to Fred? Because it’s not his residence (the foreclosure of your personal residence is taxed differently), when he turns his rental house over to the bank in foreclosure, it’s treated for tax purposes as if he sold it to the bank for the amount of debt that he owes on the building. Using the numbers in my example, Fred will be taxed as if he sold the property for $600,000.

Fred would report the transaction on his tax return as a sale for $600,000 less his tax basis of $250,000 (which would actually be adjusted for depreciation and improvements). This means he would have a taxable gain of $350,000 for which he will owe tax to the IRS and to the State. Depending upon how the loan on the property was structured, this gain might even be taxed as ordinary income rather than capital gains. Obviously Fred doesn’t have the means to pay this tax because if he did he wouldn’t be losing the property in foreclosure.

Is there a way out of this problem? Of course! do a 1031 exchange!

If Fred does a 1031 exchange, his gain will roll over to his new property. To do an exchange that is entirely tax free, however, he will need to buy a new property worth at least $600,000. How will he do that if he doesn’t have any cash? Good question, and that’s one of the big problems with short sales. Another problem is that Fred’s credit is trashed because of the foreclosure.

The most common solution we’ve seen our clients use to overcome this problem is they buy a property with substantial owner financing. Typically the buyer will try to negotiate the terms of the owner-carry to maximize their cash flow. The downside is these types of properties typically have problems that need to be fixed, (such as bad tenants). But the good news is that there are sellers who might be willing to work with you just to get rid of their problem, especially in these economic times.

So before you automatically commit to a large tax bill, check with your Realtor to see if you can’t find a property and a seller that is willing to work with you in a way that will solve a problem for both of you.