Sometimes investors will buy a property, it'll go up in value and when the value is high they'll refinance the property and extract a lot of the equity. Oftentimes, the property will then decline in value such that the debt on the property exceeds the value of the underlying collateral property.
A Potential Tax Problem
So now if you sell that property or have an involuntary sale such as a foreclosure, you may find that you have a sale for tax purposes and that you have a gain on the disposition (because your gain is determined by the difference in the debt relief and your basis). So you may have a low basis, high debt amount particularly if you're giving the property back to the bank. You may have a tax problem because for tax purposes you've conducted a sale in which you have a gain, but in reality you have no cash proceeds because your property is under water.
1031 Exchanging Underwater Property
How do you do a 1031 when you're trying to defer a gain and you have no sales proceeds to reinvest into a replacement property?
The answer is you have to acquire a replacement property - typically the target would be highly leveraged replacement property in which you don't have to put a lot of cash down. Somehow you're going to have to scrape together enough financial resources to acquire a replacement property of equivalent or greater value and which would have enough debt associated with it that you'll be able to offset the debt relief on your old relinquished property.
You may have to scrape, scrimp, beg and borrow to acquire the down payment to get a sufficiently big enough replacement property to cover all the debt relief of the disposition of your old relinquished property. But the benefit of doing so is you keep the taxman at bay and defer those gains indefinitely into the new property.
Start Your 1031 Exchange: If you have questions about 1031 exchanges of underwater property, feel free to call me at 612-643-1031.
Defer the tax. Maximize your gain.
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