Utilizing a 1031 Exchange in a Workout Situation



During recent years, real estate prices have dropped and foreclosures/deeds in lieu have increased. Economically distressed properties have been repossessed by lenders in transactions void of any cash profit to their owners. Nevertheless, federal income tax law treats these transactions as sales, which may have adverse tax consequences. Section 1031 may help defer phantom gain on the disposition of distressed property in these situations. Where the loan is nonrecourse, the amount realized on the disposition of the property would be the principal amount of the nonrecourse liability. The realized gain would be the difference between the basis in the property and the amount realized on the loan. The use of a Qualified Intermediary is a valid safe harbor in an exchange which involves no cash or other property.

To facilitate a 1031 exchange, the taxpayer and the Qualified Intermediary, QI, enter into a written exchange agreement. Pursuant to that agreement, the QI must: (i) acquire the relinquished property from the taxpayer; (ii) transfer the relinquished property; (iii) acquire the replacement property; and (iv) transfer the replacement property to the taxpayer. In a Deed in Lieu situation, the Borrower and Lender will execute an “Agreement in Lieu of Foreclosure” specifying the terms of the conveyance. In anticipation of a Section 1031 exchange, the taxpayer should include an exchange cooperation clause in such agreement.

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