The real estate market continues to stumble through one of the most difficult cycles in its history. Real property owners are faced with numerous hurdles and challenges when “surviving” a real estate market like this, including losing their real property, whether it be their primary residence or an investment property, through a fire sale, short sale, foreclosure action or deed-in-lieu of foreclosure transaction.
More Than Emotions, Anxiety and Fear
Real estate owners who are losing their property not only experience all sorts of emotions, anxiety and fear, they also have a wide range of questions, concerns and problems to deal with. Their concerns range from losing equity in their property (if any), to what kind of income tax consequences they may be faced with, to how the transaction will affect their credit rating. The loss of their real property may even affect their business operation if the property is used in their business.
Income Tax Consequences
Perhaps the most frustrating of these issues is the potential income tax consequences. Owners often incorrectly assume that if they are losing their property, especially property held for rental or investment, and have no equity in their real property that they have no income tax consequences. They’re often in for a painful surprise when they file their tax return. Especially if the owner’s deemed “sales price” is greater than their adjusted cost basis in the property.
Refinancing Creates the Problem
Property owners are generally shocked when we discuss the potential for income tax consequences. They have a difficult time getting their heads around the fact that they are selling or losing a property and receiving no cash or equity at the closing but will still owe capital gain taxes.
The cash pulled out of a property by refinancing over the years represents some or all of their equity or profit, but they have not paid any capital gain taxes yet.
Exclusions and Exemptions For Primary Residence, But Not Investment Property
There are a number of exclusions and exemptions for the disposition of an owner’s primary residence, but there are virtually none to save the real estate investor when they lose investment property. So, careful planning is required once the investor has a handle on the income tax consequences.
Taxable Gain From Short Sale or Foreclosure
A taxable capital gain will result from a short sale, foreclosure action or deed-in-lieu of foreclosure transaction, if the investor’s outstanding mortgage debt on their rental or investment property exceeds their adjusted cost basis in the property.
The transfer of the investment property through a short sale, Trustee’s Sale (foreclosure action) or deed-in-lieu of foreclosure transaction is treated in part as if the investment property was sold. The amount of capital gain that is recognized depends on whether the loan is recourse (e.g., the lender can go after the borrower) or nonrecourse (e.g., the lender can not go after the borrower).
The real estate investor is treated for income tax purposes as:
(i) having cancellation of indebtedness income or “debt forgiveness” to the extent that the outstanding loan amount exceeds the fair market value (“FMV”) of the investment property, and a capital gain or loss equal to the difference between the actual fair market value of the investment property and the investor’s adjusted cost basis for tax purposes when the debt is recourse to the investor; and,
(iii) in the case of a nonrecourse loan, the real estate investor would recognize a capital gain equal to the difference between the outstanding loan amount and the real estate investor’s adjusted cost basis in the investment property.
Proactive Income Tax Planning
It is absolutely critical that property owners understand exactly what their income tax consequence will be for each specific transaction. They need to have their tax advisor review any potential transaction before the transaction closes.
Unfortunately, the income tax consequences of a short sale, foreclosure action or deed-in-lieu of foreclosure transaction are often reviewed only after the investment property has been lost and it is too late to do anything about the taxable gain.
“However, with proactive planning, the real estate investor can potentially defer the income tax consequences from a distressed sale of property by structuring a Zero Equity 1031 Exchange™,” according to William L. Exeter, co-founder of The Center for Wealth & Legacy™ and president and chief executive officer of Exeter 1031 Exchange Services, LLC.
Zero Equity 1031 Exchange
This income tax planning concept is relatively straight forward. It involves structuring a 1031 Exchange transaction for the disposition of the investor’s relinquished property even though it is being lost through a short sale, foreclosure action or deed-in-lieu of foreclosure transaction. The cash that would otherwise be needed to pay the investor’s capital gain taxes would be used to acquire like kind replacement property through the Zero Equity 1031 Exchange. It gives the struggling real estate investor options that they may not have had otherwise. This tax planning tool does require outside-the-box thinking and creative acquisitions since there is no equity (cash) to be used to acquire the replacement property. It will save real estate investors a create deal of money and help to rebuild our struggling market.