Discussion:1031 Exchange and Foreclosure

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Discussion Forum Index --> Advanced Tax Questions --> 1031 Exchange and Foreclosure
Discussion Forum Index --> Tax Questions --> 1031 Exchange and Foreclosure

RealtorTax (talk|edits) said:

15 July 2009

In September of 2008, my client did a 1031 exchange of investment property (vacant land). Since then, their financial condition has worsened and as a result, their lender is foreclosing on their investment property. In all likelihood, the selling price should surpass their mortgage balance. But they are concerned that the foreclosure could somehow cause the IRS to retroactively disallow 1031 treatment, and thus they will be responsible for paying tax on the built-in capital gains. Their rationale (which I understand, but don't know if it is accurate) for believing that 1031 treatment may potentially be disallowed is that because they are no longer holding the property for productive use in their trade/business, the IRS can disallow it.

I'm inclined to believe that the IRS wouldn't retroactively disallow 1031 treatment because there is no evidence to indicate that at time the last exchange took place (Sept. 2008), the taxpayer's intention was to hold the property in accordance with the requirements of a proper 1031 exchange. Their intentions have never wavered.

Will 1031 exchange treatment be upheld or disallowed in this case?

EZTAX (talk|edits) said:

15 July 2009

Not totally sure but I can't imagine the 1031 will be disallowed. However they will most likely owe capital gains that will be affected by the 1031. They will have to pay tax on the "bulit in capital gains".

It is all about basis vs mtg balance. Property will be sold at FMV. The difference between the sale price, less commissions, and the basis will be taxable. The basis will be the original basis of the previous property plus any additional amounts invested in the property when purchased or since then.

Bottom line. Client's concerns are well founded.