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1031 Exchange
When You Have Negative Equity
As a result of
the current real estate slowdown, we’re starting
to see clients selling properties with negative equities. By
negative equity, I mean situations where they might
owe more than the property is worth they can sell the
property for. Because of this, some interesting
questions arise. How does negative equity affect
a persons ability to do a 1031 exchange? Can
you do an exchange when you owe more than the property
is selling for? Why bother if there is no cash,
or if you have to bring cash to the table?
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by
Author Gary Gorman
Founding Partner,
1031 Exchange Experts, LLC |
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Most people (even many real estate
professionals) tend to think of cash as the same as “gain.” Therefore,
according to their thinking, if you don’t receive
any cash from a sale, you don’t have any gain. And
if you, as the seller, have to bring cash to the closing,
you must have a loss, right?
Wrong! In tax law, there is no
correlation between “cash” and “taxable
gain.” Let’s take Fred and Sue as
an example. They bought their purple duplex for
$25,000, put $5,000 of improvements into it, and have
taken depreciation totaling $10,000 over the years. Their
tax basis in the duplex is $20,000 ($25,000, plus $5,000,
minus $10,000). If they sell it for $100,000,
they will have a gain of $80,000, which will be taxable
if they don’t do a 1031 exchange. And keep
in mind, regardless of the amount of equity they
have in the property, they have $80,000 of gain.
Let’s take this example a little
further, last year the property was appraised at $125,000,
and they were able to refinance it and get an 80% loan
of $100,000. Now, a year later, one of the tenants
has moved out and caused significant damage in the
process. The duplex is 50% vacant and has tenant
damage that needs repair. Fred and Sue have an
unsolicited offer of $90,000 for the property, as-is,
and they want to take it. Since there will be
no cash (or equity) to them from the sale, should Fred
and Sue even bother doing an exchange? The answer
is Yes! We will explain why in the next article
in this series.
Remember in our last article, Fred
and Sue owned a purple duplex. Over a year ago
they refinanced it and took out $100,000 of cash based
on their appraisal of $125,000. The market has
now turned they have lost their tenant who has done
significant damage to the property. They have
an unsolicited “as-is” offer in hand for
$90,000 and they want to accept it. They come
to you as their agent and want to know whether it makes
sense to do a 1031 Exchange.
As you recall since Fred and Sue owned
the property for so long, they will have a gain of
$70,000. Therefore, the answer is YES! – even
though Fred and Sue will receive no cash from the sale,
they still have a gain of $70,000 in this property. Without
a 1031 exchange, they will owe approximately $15,000
in federal and state taxes.
There are some things they need to
be careful of however, when they do the exchange. The
first is that they still need to retain a Qualified
Intermediary to prepare exchange documents for them
(for both the sale of their Old Property and the purchase
of their New), even though there is no cash from the
sale. And second, even though they have no cash
from the sale, they still need to buy equal-or-up,
meaning that they will need to purchase a New Property
for at least $90,000.
In summary – Fred and Sue will
receive no cash from the sale of their property, and
in fact, they will bring $10,000 to the closing. Even
worse, without a 1031 exchange, they will
be out-of-pocket an additional $15,000 for taxes, plus
closing costs! Fred and Sue almost HAVE to do
an exchange. The taxes will make a bad situation
even worse. So, even when there is negative equity
in a property, it often still makes sense to do a 1031
Exchange.
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