Short Sales and 1031 Exchanges

Short sales are everywhere today. But, the question that still remains is how to combine short sales with 1031 exchanges. The answer is simple, but the application may be not so easy to implement. Most sellers engaged in a short sale are selling their primary residence or are selling the property at a loss. In either case, a 1031 exchange is not available or advisable. So, the following discussion will focus on using a short sale to buy the targeted replacement property to hold for investment or business-use as part of a 1031 exchange.

A short sale occurs when a seller negotiates with the mortgage holder(s) to release the mortgage(s) so the residence can be sold. In a short sale, the selling price is generally less than the outstanding balances of all mortgages, closing costs, and other liens, such as taxes. Thus, clear title to the property cannot be delivered without a mortgage discharge and the mortgage discharge will not be granted unless the full amount of the mortgage is paid at the closing or if the mortgage holder agrees to accept an amount less than the full outstanding balance. In cases where the mortgage holder agrees to discharge the mortgage upon payment of less than the full amount, the property owner must supply certain documents and statements to the mortgage holder proving hardship. Even in such cases, the mortgage holder generally reserves the right to sue the borrower for the deficiency. But, at least the property can be sold at the highest price possible, thereby limiting the harm to both the property owner and the mortgage holder.

The short sale process can take a long time. Many mortgage holders such as Bank of America, Citimortgage and others have established departments and formal procedures for handing the large numbers of property owners seeking short sales. And, before a mortgage holder will approve a short sale, all of the required documentation must be submitted along with a signed purchase and sale agreement.

The exchanger in a 1031 exchange has 45 days from the sale of the relinquished property to identify the potential replacement properties and 180 days to acquire one or more of the properties that have been identified. An exchanger typically begins looking for the potential replacement properties prior to selling the relinquished property, but generally does not sign a contract until after the closing of the relinquished property.

An exchanger who desires to acquire a replacement property in a 1031 exchange through a short sale must factor in the time generally required to successfully maneuver through the short sale process. Most of the mortgage holders take weeks, if not months, to approve a particular short sale. In addition, the speed by which the process is handled depends to a large degree on the competence of the person handling the short sale approval request. Sometimes the negotiations are handled by the Realtor, sometimes by an attorney, sometimes by the seller, and sometimes by specialist whose only job is negotiating short sales. Relationships, experience, and general knowledge of short sales is essential in moving rapidly through the process. McLaughlin & Quinn, LLC partner Thomas P. Quinn, Esq. frequently represents property owners in short sales and can attest to the length of the short sale process. According to Attorney Quinn, "The mortgage holders are geared up to handle short sales, but even when the application is complete, the process can drag on seemingly forever. But, at the end of the day, most reasonable requests are approved. Patience and persistence pay off in the end."

Short sales offer tremendous buying opportunities for exchangers and other real estate investors, but the extended time period for closing the deal could test the limits of the 180 day replacement period. Experienced exchangers include sufficient conditions in the contract and make an educated analysis of the time restrictions.

For more information on how short sales work with 1031 exchanges, contact All States 1031 Exchange Facilitator, LLC owner F. Moore McLaughlin, IV, Esq., CPA, CES® by e-mail at fmm@allstates1031.com or Alexandra L. Hart at ahart@allstates1031.com or either of them toll-free at 877-395-1031.