You may be thinking "why would I need a 1031 exchange if I'm going through a short sale.  The answer is easy, and one that many investors going through a short sale have not even thought of. 

Short Sale Scenario

Our story begins with an investor has been acquiring and accummulating rental property over the last five years.  The investor refinances all of his or her rental properties every six to twelve months in order to pull the cash equity out of the property and acquire more investment property.  They maintain the loan-to-value ratio as close (as high) to 100% as possible.  The easy credit markets have allowed this to continue. 

Now, the real estate markets are in a free fall.  The investor's market value of his or her properties has dropped well below what he or she owes on the property.  Renters begin to move out and rental income begins to drop.  They are no longer able to service the debt because the cash flow has dropped too much.

They have no choice but to sell the property and complete a short-sale. 

Capital Gains

Let's say the investor acquired the property for $100,000.00 (cost basis) and that the property increased in value to $500,000.00 (fair market value).  The investor was able to refinance over a period of time and has outstanding debt of $450,000.00 (90% loan-to-value ratio).  The property value has now dropped to $300,000.00.  The investor owes $150,000 more than what the property is worth, so they decide to sell for $300,000.00 and complete a short-sale. 

Here's the catch.  The investor sells the property for $300,000.00, but they have a $100,000.00 cost basis, which translates into a $200,000.00 CAPITAL GAIN.  They are still going to owe taxes on the $200,000 capital gain even though they have sold the property and have NO EQUITY.  Investors often get equity and gain confused.  This problem could be avoided if the investor had consulted with his or her tax advisor before proceeding.

ZERO EQUITY 1031 EXCHANGE^TM 

One possible solution is to defer the payment of the investors depreciation recapture taxes and capital gain taxes by structuring and completing a Zero Equity 1031 Exchange^TM (the phrase was coined and trademarked by Exeter 1031 Exchange Services, LLC in April 2009).  The Zero Equity 1031 Exchange^TM allows the investor to sell the troubled property, complete a short-sale AND structure a 1031 exchange in order to defer the payment of the capital gain taxes.

The structure is easy.  It works like any other 1031 exchange except their is no equity or cash position for the 1031 exchange Qualified Intermediary to hold during the 1031 exchange process.  The challenge for the investor is to find a way to buy and finance replacement property as part of the 1031 exchange.  Click here to read the entire story on the Zero Equity 1031 Exchange. 

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