Underwater property and like-kind exchanges.

• Author: Belanger, Holly

The like-kind exchange rules may allow taxpayers to defer gain (or loss) realized on the exchange of property. Qualifying for like-kind exchange treatment becomes more complicated if the property exchanged is "underwater"--that is, the debt on the property exceeds its fair market value (FMV). The IRS concluded in a letter ruling that the exchange of underwater property with the lender in satisfaction of the debt could qualify for like-kind exchange treatment. This item considers what this ruling means for taxpayers in similar situations.

A taxpayer that sells investment property or property held for productive use in its trade or business may be able to defer the recognition of any gain (or loss) realized on the sale for federal income tax purposes if the sale is structured as part of a like-kind exchange under Sec. 1031. In general, to qualify for deferral under Sec. 1031, the proceeds from the sale of the property must be timely reinvested in like-kind property.

What if the taxpayer has no net equity in the relinquished property or the property is underwater? The taxpayer will receive no proceeds (other than relief from indebtedness) from the disposition of the property to reinvest in like-kind property. Can a taxpayer still use the like-kind exchange rules of Sec. 1031 to defer the gain realized on the transfer of underwater property to the lender in satisfaction of a nonrecourse debt? This item discusses a recent letter ruling issued by the IRS regarding the exchange of underwater property by a taxpayer under Sec. 1031. The recent letter ruling and this item discuss property encumbered by a nonrecourse liability. Additional analysis may be required if the liability is recourse.

Example: A holds Property X for productive use in its trade or business. The FMV of Property X is $100, and it is subject to a nonrecourse liability of $125. A's tax basis in Property X is $80. A has entered into an agreement with the lender on the nonrecourse liability to return Property X to the lender in full satisfaction of the nonrecourse liability. A's net equity in Property X is zero. A will realize $45 of gain ($125 amount realized less $80 basis) on the disposition to the lender. Can A structure the disposition of Property X to the lender as a like-kind exchange under Sec. 1031 and, thus, defer for federal income tax purposes the recognition of gain realized on the disposition?

In general, Sec. 1001(c) requires a taxpayer to recognize the amount of gain...