Is a Deed in Lieu of Foreclosure a Viable Option for a 1031 Exchange?

Deed in Lieu of Foreclosure - 1031 Exchange Potential?

Burdened by too much debt and beleaguered by falling property values and strained cash flows, many investors are choosing to walk away from their equity and their properties – turning the keys over to the lender perhaps to avoid a judicial foreclosure, or contemporaneously with a foreclosure filing.

When debt is discharged for an amount less than its face value, the borrower may be required to recognize income on the amount of debt forgiven. The theory that forgiveness of debt creates taxable income stems from the idea that when loan proceeds are originally received by a borrower, they are not subject to income tax.

The loan proceeds represent an asset – funds that may be used by the borrower in any way the borrower sees fit. That asset is offset by a liability of equal value, namely, the requirement that the loan be paid back.

Generally, simultaneously with the borrowing, there is some tax benefit realized by the borrower: tax-free use of loan proceeds or an addition to basis when acquiring financed property. If the loan is subsequently forgiven or discharged at a discount, the borrower must (with certain exceptions) include that amount in gross income as an offset to the original favorable tax treatment.

Can a tax-deferred exchange be successfully completed in a situation where an investor transfers encumbered property to its lender in lieu of foreclosure? What are the implications? If an investor is so upside down on their debt that they are facing possible foreclosure, what is the likelihood that an exchange would be successful?

The IRS considers the transfer of encumbered property back to a lender, in lieu of foreclosure, as a sale that is subject to recognition of gain or loss under Section 1001. Worse yet, if the debt is nonrecourse, the entire amount of debt is included in calculating the amount realized from the sale – regardless of whether the debt exceeds the current fair market value of the property.

Structuring a tax-deferred exchange around a transfer of property in lieu of foreclosure is one way to delay the recognition of gain.  The issues are complex but if structured correctly, the result can be meaningful.

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