Taxpayers engaged in a 1031 exchange will often include short sale and foreclosure properties in their mix of potential replacement properties. A 1031 exchange allows the deferral of federal and state capital gains and recaptured depreciation taxes when a property of equal or greater value is acquired. The tax deferral is an indefinite postponement of the tax triggered or due when the replacement property is sold, unless another 1031 exchange is initiated.
Short Sale vs. Foreclosure
A short sale is when real property like a single family home, condominium or vacation rental is sold for less than the debt on the property. The property is considered underwater when the mortgage balance is greater than the market value. Most lenders will not consider a short sale until the titleholder is 90 days late or more on their mortgage payments. Completing a short sale requires a seller with a hardship, an experienced Realtor, a willing bank or lender, an experienced negotiator and a buyer. If the negotiator who works with the lender has a streamlined process, the short sale can happen in as little as six months or as long as three years. The lender has the option to deny the Purchase and Sales Agreement (PSA). Once that happens, the process starts at the beginning with a new PSA.
Foreclosures, like short sales, result when the titleholder is behind on their mortgage payments. Typically, the first step for both a short sale and foreclosure is for the lender to file a lis pendens or a public notification recorded in the county’s recorder office that the real or personal property is involved in a pending lawsuit to claim their financial interests. The titleholder receives the notice of the pending law-suit from a servicer such as the local sheriff’s office. Eventually, a hearing before a judge is scheduled and given the facts presented support the lender’s case, a judgment is awarded and sale scheduled.
The difference between a short sale and foreclosure is the titleholder is in control of which PSA to present to the lender. The titleholder may be able to live in the home for a longer period of time than in a foreclosure. Each state has different rules regarding the interests of the home owner. Both the short sale and foreclosure will negatively impact the titleholder’s credit rating for many years.
1031 Exchange Process
Following the initial relinquished or old property sale, replacement properties must be formally identified no later than 11:59 PM on the forty fifth calendar day following the sale. The property’s addresses are submitted to the Qualified Intermediary (QI). The replacement property can be acquired in an auction or short sale closing prior to the 45th day without the need to later identify. The QI wires the exchange funds to the County Trustee and the property is acquired. If the property is to be sold following the 45th calendar day, then the QI complies with the local authority procedures to wire the funds for the purchase.
In both a short sale and a foreclosure the question is timing. In a short sale, the closing is scheduled once the bank accepts the PSA. If the property is formally identified and the bank does not accept the offer, then hopefully one of the other properties identified can be closed. If not and the short sale property is the only property identified, then the exchange fails and the exchange proceeds are returned to the taxpayer and tax imposed. It is best to identify multiple properties to have a contingency.
In both the short sale and foreclosure, the lenders will typically not allow an assignment of the PSA to the QI, sign a notice of assignment or allow changes to the name of the buyer on the settlement statement. This will not nullify the 1031 exchange.
In January, 2011, “short sales accounted for 23.9 percent of home purchases … compared to 19.7 percent of sales of foreclosed homes … a year earlier, 16.3 percent of transactions were short sales and 24.9 percent involved foreclosures.” Short sales can be less expensive than foreclosures for the lender. Both short sales and foreclosures represent eligible 1031 replacement properties. Whether the closing can be finalized within the 180 calendar day window is the prime issue.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
