I know it sounds weird but it could help an investor in a very specific set of circumstances.
In the last post we examined the options available for taxpayers who had debt forgiven or canceled on their principal residence. But what about those who own investment property who are facing a short sale or foreclosure? Are there tax consequences when debt is forgiven or canceled on those types of properties? You bet!
Given the challenging conditions in the real estate market, some taxpayers may be faced with the prospect of foreclosure or a short sale arrangement with their lender. Taxpayers in this situation have a multitude of concerns ranging from a deteriorating credit rating to loss of their equity. Unfortunately, the taxpayer may have a significant tax liability that arises out of foreclosure or short sale.
LOSE PROPERTY IN FORECLOSURE BUT MAY OWE CAPITAL GAIN TAXES
A tax liability could occur if the indebtedness encumbering the property is greater than the taxpayer’s adjusted basis for income tax purposes. This happens because the transfer of the property to the lender or short sale buyer results in debt forgiveness. This usually happens in cases where the relinquished property is highly leveraged through cash out refinancing, has declined in value or has been significantly depreciated. The capital gain is recognized whether the property is conveyed through foreclosure, short sale or a deed in lieu of foreclosure. In these instances, taxpayers have a capital gain tax liability even though they will not receive cash with which to pay the tax liability.
WHAT CAN BE DONE TO MITIGATE THE TAX EXPOSURE?
Remarkably, all is not lost to a taxpayer who has some cash (which is really a long shot if they're in this situation already but this is a potential option) and would like to continue to invest in real estate. If the transaction is properly structured, the taxpayer could elect to complete a §1031 tax deferred exchange treating the mortgaged property as the relinquished property. In order to qualify, the transaction should be structured as either a short sale or a deed in lieu of foreclosure. If the property is foreclosed the transaction is not easily converted into an exchange because the transfer of the relinquished property occurs by operation of law. This leaves no room for an exchange agreement and the integration of a qualified intermediary into the transaction.
With a deed in lieu of foreclosure, it is critical that exchange documents be signed by the taxpayer prior to the property being deeded to the lender, as the deed to the lender commences the running of the 45 day identification period and the 180 day exchange period. During the exchange period, the taxpayer must acquire replacement property of equal or greater value to the relinquished property in order to defer 100% of their capital gain tax liability. The obvious hurdle to performing such an exchange is that the taxpayer must have enough cash available to make a down payment on the replacement property and be able to finance the remainder of the purchase price.
The above consequences highlight the need to involve legal and tax advisors in connection with all investment decisions. Failure to do so may result in a taxpayer incurring unintended tax liabilities that could have been deferred had the transaction been reviewed early on by the right professionals.
THIS INFORMATION IS PROVIDED FOR EDUCATIONAL AND INFORMATIONAL PURPOSES ONLY. IT IS NOT TAX OR LEGAL ADVICE. INDIVIDUALS ARE STRONGLY ENCOURAGED TO SEEK GUIDANCE FROM THEIR OWN TAX AND LEGAL ADVISORS REGARDING THE SPECIFIC FACTS AND CIRCUMSTANCES OF THEIR SITUATION.
Lisa A. Lambert, Esq. 877.646.1031 or LisaL@apiexchange.com