Distressed sales continue to account for a significant portion of the sales volume in many markets. Investors with access to cash are acquiring properties in short sales, auctions and foreclosures, and in some cases they are selling properties in a 1031 exchange and using their exchange funds to acquire these distressed properties.
Investors who sell property in an exchange and use the funds to acquire property that is being sold by a lender in a short sale, auction or foreclosure need to keep in mind the 1031 exchange rules that may complicate the process.
In a short sale, the bid package must be approved by the lender that owns the property, and in some cases this approval may take longer than expected. Lenders appear to be approving packages more quickly, but an investor needs to pay attention to the timing. In a 1031 exchange, the investor must identify replacement property within 45 days and close within 180 days after the close of the property being sold (relinquished property).
In order for a sale followed by a purchase to be considered an exchange for tax purposes, the investor cannot have control of the funds from the sale. The qualified intermediary must hold the funds and the regulations say that the funds should only be delivered to the seller of the replacement property after the investor assigns to the intermediary his rights under the purchase contract. If the funds are sent (as a deposit or as the purchase price) to the seller before the investor assigns his rights under a signed purchase agreement to the intermediary, there is a possibility that the 1031 exchange could be disqualified.
Because of this rule, it can be difficult to acquire foreclosure or auction property in an exchange. In a foreclosure, there is no contract to assign. In an auction, there may not be a contract, but even when there is a contract, the seller often requires the successful bidder to make a deposit before the contract is signed. In that case, investors will sometimes use their own funds to make the deposit rather than risk causing their exchange to be disqualified.
In a short sale, some lenders will also require a deposit before the lender will sign the purchase agreement. In order to avoid the constructive receipt issue, many investors will use their own funds to make the deposit and get reimbursed later from their exchange funds.
In a 1031 exchange, the investor must assign its rights to the qualified intermediary under the purchase and sale agreement, and all of the parties to the transaction must be notified of this assignment. Typically, in a replacement property closing, the seller signs a document acknowledging notice of this assignment; however, in some cases a lender selling property in a short sale may refuse to sign this acknowledgement. One solution that some investors use is to ask the escrow agent or closing agent to state in writing that they sent the notice of assignment to the lender. This gives the investor evidence that they have complied with this requirement in case they are audited.
Another typical practice in an exchange is to show the qualified intermediary as the seller or buyer on the settlement statement. Sometimes lenders who are selling property in a short sale won’t allow escrow to list the intermediary on the statement. Although this is not ideal for the investor, most tax advisors feel that it should not adversely affect the exchange as long as the exchange documents are signed before the closing of the relinquished property and the investor does not touch any of the exchange funds.
It also may be difficult to do a reverse exchange when the qualified intermediary is taking title to property that is being sold in a short sale because the lender may not allow the intermediary to go on title. This possibility should be explored before planning a reverse exchange with property being sold in a short sale.
All of these details should be thoroughly investigated and resolved before attempting to combine a 1031 exchange with a short sale, foreclosure or auction.
from The Exchange Update Newsletter by First American Exchange Company