Foreclosures and 1031 Exchanges

Investors facing foreclosure are sometimes surprised to discover that they also have a tax problem. Despite the lack of equity, the foreclosure of some properties will result in taxable gain to the owner. How does this happen and what can investors do to address this issue




Most real estate loans are non-recourse; in other words, without any personal liability to the borrower. Upon foreclosure, the borrower loses all of his equity in the property, but is not at risk of losing his other assets in order to pay the debt. For example, if an investor owns property with a fair market value of $150 and a loan balance of $200, upon foreclosure the borrower loses the property but is not liable to the lender for the $50 shortfall.


For tax purposes, the foreclosure of property with non-recourse debt is considered a sale of the property for a value equal to the balance of the debt. In the case mentioned above, the foreclosure of the property would be considered a sale of the property with a sales price equal to $200. To compute the realized gain, you would subtract the basis of the property from this sales price. Particularly if the property was acquired as replacement property in an earlier exchange, the basis could be quite low and because of that, there may be significant gain even if there is no equity.




Most tax advisors agree that an investor can defer capital gains tax which is due upon foreclosure by exchanging the property in a 1031 exchange. These exchanges are uncommon; however, investors facing foreclosure should be aware of the potential to defer tax using a like-kind exchange.




Internal Revenue Code Section 1031 does not require equity in order to complete a 1031 exchange; however, from a practical standpoint, the lack of cash is a huge issue for most investors. The investor will need to obtain financing and cash to fund the acquisition. In order to completely defer all tax, the replacement property will need to have a fair market value equal to or greater than the balance of the debt for the relinquished property. This can be accomplished with any combination of debt and equity.




When property is foreclosed upon, it is sold at auction and there is no contract between the seller and the buyer. This is an issue when attempting to exchange foreclosure property because, in order to have a valid exchange, the investor must assign his rights in the sale agreement to the Qualified Intermediary, and the buyer must be notified of that assignment.


An alternative to assigning the contract to the Qualified Intermediary is to have the Intermediary actually take title to the relinquished property before the foreclosure. There are legal issues which have to be addressed with this structure, but the arrangement is similar to reverse exchanges, where entities affiliated with Qualified Intermediaries also take title to property to facilitate the exchange.


The tax effect of a foreclosure where the debt is recourse varies from what is discussed in this short article. In addition, some investors may want to negotiate other solutions, such as a pre-foreclosure sale. We recommend that you call your tax advisor to discuss these issues, and call First American Exchange if you would like to set up a 1031 exchange or have any questions.