Mixing a 1031 exchange and a short sale can be done, but often times cannot. Timing can have alot to do with it. A 1031 exchange allows the taxpayer to defer the federal and state capital gains and recaptured depreciation taxes when selling real estate held in the productive use of a business or for investment. After aggregating the taxes triggered upon sale, the tax can be as high as 40 percent of the sales price. If the taxpayer, who can be an individual, husband and wife, trust, corporation, or domestic or foreign follows the 1031 rules, those taxable dollars can be used towards purchasing replacement property and the taxpayer effectively receives an indefinite interest free loan. The tax is ultimately due when the replacement property is sold, unless deferred again in another 1031 exchange.
1031 Exchange Rules
A 1031 exchange must be completed within 180 calendar days post-closing on the sale of the initial property. By the 45th calendar day post-closing on the old property, the taxpayer must formally submit to the qualified intermediary an identification of the potential replacement properties. The taxpayer who sells is the taxpayer who must buy. The value of the new property must be equal to or greater than the net sales price of the old property or a tax is triggered on the difference. If the old property is sold to a related party, such as family or entity, where the taxpayer’s ownership exceeds more than 50 percent of the stock, the related party must hold the newly acquired property for two years. Otherwise, selling it triggers the deferred tax. Purchasing the replacement property from a related party requires that the selling party must also be initiating a 1031 exchange and not cashing out.
Short Sale
A short sale is when the sales price is less than the mortgage, requiring the lender’s approval to accept less than the note and take a loss. Though lender short sales have been streamlined and become more efficient, there is potential for a great deal of give and take between the mediator and the lender. The lender has the final say as to whether they will accept the sales price.
Work with a Realtor who understands the short sale process. In turn they will suggest either an attorney or closing agent within a title company that will contact the lender’s short sale staff. Some Realtors negotiate with the lenders. Following the completion of paperwork, including a hardship letter describing why the taxpayer is not able to pay the mortgage, offers received are submitted to the lender for review. Lenders may elect to not take the first, second or third offer, delaying the sale for months if not years.
In a 1031 exchange, the taxpayer does not have the luxury of extending the 180 calendar day timeframe. If after the 45th calendar day and a short sale property is identified, a rejection from the lender could require the qualified intermediary hold the exchange proceeds until the 180th day to satisfy the (g)(6) limitations of constructive receipt of the 1031 code.
When considering a short sale, make sure to identify additional replacement properties that are not short sales. To learn about the replacement property identification requirements, read the following short article.
Short sales need to be approached with the same diligence as regular properties. Though they offer a perceived value with similar properties, the market ultimately determines the outcome. Short sales can also be rewarding, when purchasing a property that is fifty to sixty percent below the price paid during the 2004 to 2006 hyper real estate market.
Download a complimentary eBook on “Ten Reasons Why a 1031 Makes Sense” by clicking on the button below.
