1031 Exchange in Lieu of Foreclosure PLR 201302009

Typically, when a taxpayer sells real or personal property and realizes a gain from the sale, the realized gain is subject to payment of capital gains taxes. One option that taxpayers frequently use to temporarily avoid the payment of capital gains taxes is to enter into a Section 1031 Exchange in lieu of a traditional sale. If a transaction qualifies for Section 1031 treatment, any capital gains taxes that would otherwise be due on the realized gain are deferred.

Private Letter Rulings

While many 1031 Exchanges are straight-forward and uncomplicated, others are not. When a proposed exchange brings up new issues or heretofore unchartered territory, the taxpayer may request a ruling ahead of time from the Internal Revenue Service in the form of a Private Letter Ruling, or PLR. Although a PLR is only directly applicable to the facts and circumstances presented in the PLR, it often provides guidance to other taxpayers facing similar issues. PLR 201302009 addresses how a foreclosure can potentially be structured to meet the requirements of a Section 1031 Exchange.

PLR 201302009

In PLR 201302009, taxpayer was an LLC that owned real property used in the company’s trade or business, meaning it met one important requirement for a Section 1031 Exchange. The property was subject to a non-recourse mortgage debt. In addition, the fair market value at the time of the proposed exchange was significantly less than the debt owed on the mortgage. Taxpayer was facing foreclosure on the property. Although the lender agreed to take the property subject to the mortgage debt, doing a straightforward deed in lieu of foreclosure (DIL) would have created a significant tax liability for taxpayer. Taxpayer, therefore, wished to structure the transaction in a way that the transaction would qualify for Section 1031 Exchange treatment as well, thereby deferring any gain realized from the transaction.

To qualify for Section 1031 treatment, a taxpayer is required to use a Qualified Intermediary, or QI, to facilitate the exchange. The QI must invest all of the proceeds from the relinquished property into the replacement property for the transaction to qualify. Although there is technically no gain realized in a DIL, taxpayer was concerned about the difference in the fair market value of the property versus the actual debt owed on the mortgage and how that affected the transfer of the relinquished property to the QI as required in the Section 1031 rules.

The PLR concluded that the value to be used in the calculations for the exchange was the value of the debt owed on the mortgage, not the fair market value of the property. Therefore, the transfer to the QI would be for the full amount of the mortgage debt. To effectuate the transfer, taxpayer would assign its rights in the Transfer Agreement (the agreement between taxpayer and lender to avoid foreclosure) for the property to the QI. Taxpayer would then locate replacement property valued at the amount owed on the mortgage or more. The rights to the agreement for the replacement property would then be assigned to the QI as well. According to IRS rules, as long as all parties to the agreements are notified in writing of the transfer of rights to the QI then the QI is treated as having entered into the agreements, thereby satisfying the requirement that the QI acquire and transfer the property.

For a taxpayer who is facing foreclosure and is considering a deed in lieu of foreclosure, pursuing a Section 1031 Exchange as part of the DIL agreement may be an excellent option to defer any potential tax liability resulting from the transaction.

To understand more about Section 1031 Exchange, download the free “1031 Exchange Checklist” by clicking here for issues taxpayers entering a 1031 exchange should know.