IRS Blesses Tax-Free Exchange of Negative-Equity Property
Section 1031 of the Internal Revenue Code provides that property owners do not recognize gain on the exchange of certain like-kind property.1 The opportunity to avoid gain recognition makes section 1031 exchanges popular, especially among owners of real property. In a recent private letter ruling, the IRS decided that even gain from property with negative equity can qualify for section 1031 nonrecognition.2 Avoiding gain recognition on the disposition of negative-equity property can be particularly appealing to owners of property that is subject to foreclosure or transfer in lieu of foreclosure.
An example helps illustrate this point. Assume that Dawn purchased Triumph Tower for $1,500,000 in 1996. In 2007, Dawn and Big Bank believed the property was worth $4,000,000, and Big Bank granted Dawn a $3,200,000 nonrecourse loan secured by the property. In 2009, the parties believe the property is only worth $2,500,000 and Dawn and Big Bank begin to discuss how to deal with the $3,000,000 outstanding balance on the loan. They ultimately decide that Big Bank will simply take title to the property in satisfaction of the outstanding balance of the loan. If Dawn merely transfers title of Triumph Tower to Big Bank, she will recognize gain equal to the difference between the $3,000,000 outstanding balance of the loan and Triumph Tower’s adjusted basis, which could be around $1,000,000 in 2009.3 Thus, in addition to losing the building, Dawn could owe tax on the gain she would recognize on the disposition. To avoid that gain, Dawn may prefer to transfer Triumph Tower as part of a section 1031 exchange.
The IRS private letter ruling indicates that Dawn could structure the disposition of the property as part of a section 1031 exchange facilitated by a section 1031 qualified intermediary. To do so, she would have to acquire like-kind replacement property worth at least $3,000,000, the fair market value of the relinquished Triumph Tower. That like-kind replacement property can include any improved or unimproved real property,4 a leasehold of at least 30 years in real property,5 or certain types of partial real property interests.6 As long as the value of such property is at least $3,000,000, the exchange can be tax free. The ruling by the IRS is not binding on anyone other than the person to whom it was issued, and it does not have precedence.7 Nonetheless, it provides the analysis of IRS attorneys and reflects a general understanding of the law in this area. The facts of the ruling suggest that the property owner entered into a transfer agreement with the lender, and the assignment of that agreement satisfied the requirements under the section 1031 qualified intermediary regulations.8 The ruling’s conclusion that the disposition qualifies as a 1031 exchange is consistent with some prior scholarly commentary.9 This conclusion is appropriate because the transfer agreement between a borrower and a lender should be similar to a transfer agreement between other buyers and sellers, which the section 1031 rules clearly contemplate.10
The ruling also indicates that the IRS treats negative-equity property as property for purposes of section 1031, even though in other contexts, negative-equity property does not come within the definition of property or may not qualify for tax-free treatment.11 Commentators had been advocating for this outcome for negative-equity property in the context of section 1031even before the IRS released this recent private letter ruling.12 The IRS private letter ruling, along with the reasoning in commentary, should provide comfort to other property owners facing similar situations.
Even though the private ruling provides insight into exchanges of distressed property, other questions remain. In particular, property owners must still consider how they will structure the disposition of property as part of a foreclosure sale. Because such sales often do not include transfer documents that the property owner can assign to the qualified intermediary, they may not come within the qualified intermediary safe harbor.13 Careful planning for such dispositions of property in the face of uncertainty will be the key to successful nonrecognition,14 at least until the IRS or courts provide guidance that illustrates a more convenient way to structure such dispositions to comply with section 1031.
- 1. To be more precise, section 1031(a) provides that a property owner will recognize no gain or loss on the exchange of property held for productive use in a trade or business or for investment for like-kind property to be held for productive use in a trade or business or for investment.
- 2. See I.R.S. Priv. Ltr. Rul. 201302009 (Oct. 10, 2012). Equity, for this purpose, refers to the difference between a property’s fair market value and the amount of liability to which the property is subject.
- 3. See I.R.C. § 1001(a) (2012) (providing that gain is the difference between the amount realized on the disposition and the adjusted basis of the property); I.R.C. § 1011(a) (2012) (defining adjusted basis as the I.R.C. § 1012 cost basis minus any I.R.C. § 1016 adjustments, which would include depreciation deductions); Treas. Reg. § 1.1001-2(a) (1980) (providing that amount realized includes liability discharge). In this example, adjusted basis would be the $1,500,000 cost minus depreciation on the building, which appears to be about $500,000.
- 4. See Treas. Reg. § 1.1031-1(b).
- 5. See Treas. Reg. s 1.1031-1(c)(2).
- 6. See Bradley T. Borden, The Whole Truth About Using Partial Real Estate Interests in Section 1031 Exchanges, 31 Real Est. Tax’n 19 (4th Quarter 2003) (discussing the types of partial real estate interests that come within the definition of like-kind real property for section 1031 purposes).
- 7. See I.R.C. § 6110(k)(3) (2012).
- 8. See Treas. Reg. § 1.1031(k)-1(g)(4)(iv) (as amended in 2008) (providing that the section 1031 qualified intermediary must acquire and transfer property, but an assignment to the qualified intermediary of rights in a contract can satisfy that requirement).
- 9. See, e.g., Bradley T. Borden & Todd D. Keator, Workout-Driven Exchanges, 25 Tax Mgmt. Real Est. J. 23, 28-31 (2009) (suggesting that a qualified intermediary could facilitate the disposition of property in foreclosure as part of a section 1031 exchange and that negative-equity property could be exchanged). But see Mark S. Fawer and Vincent J. Guglielmotti, Sect. 1031 Exchanges: Private Letter Ruling Offers Underwater Real Estate a Buoy, 6 Real Est. L. & Ind. Rep. 370 (2013) (observing that many practitioners could not get to a more-likely-not opinion on this issue prior to the ruling).
- 10. See Treas. Reg. § 1.1031(k)-1(g)(4)(iv).
- 11. See, e.g., Prop. Treas. Reg. §§ 1.332-2(b), 1.351-1(a)(1)(iii), 1.351-1(a)(2) (Ex. 4), and 1.368-1(f), 70 Fed. Reg. 11903, 11909-12 (March 10, 2005) (providing that in certain corporate transactions that zero-equity property does not satisfy the requirements for tax-free treatment).
- 12. See Borden & Keator, supra note 4 at 28–29 (observing that the section 1031 definition of property appears reference rights and the nature of property, with no contemplation of net value); The American Bar Association Section of Taxation, Comments Concerning Open Issues in Section 1031 Like-Kind Exchanges (July 14, 1994).
- 13. See supra note 6.
- 14. See Borden & Keator, supra note 4 at 29–31.