A client asked whether he could exchange out of a building worth less than its mortgage. Technically yes. It would not have done what he wanted, and the reason is worth understanding before anybody signs a listing agreement.
Three things go wrong at once on an underwater property, and only one of them is the one people expect.
You can be underwater and still have a gain
This is the part that genuinely shocks owners.
Gain is measured against adjusted basis, not against the loan. Years of depreciation drive basis down while the mortgage balance comes down far more slowly, and the two numbers part company.
| Amount | |
|---|---|
| Purchased in 2008 | $2,400,000 |
| Depreciation taken since | $700,000 |
| Adjusted basis today | $1,700,000 |
| Mortgage balance | $2,200,000 |
| Current value | $1,900,000 |
| Short to the lender | $300,000 |
| Taxable gain on a sale at $1,900,000 | $200,000 |
Economically he is $300,000 underwater. For tax purposes he has a $200,000 gain. Both statements are true at the same time, and the second one is the one that generates a bill.
Forgiven debt is a separate problem that a 1031 cannot touch
If the lender agrees to a short sale and writes off the shortfall, that forgiven amount is generally cancellation of debt income, taxed as ordinary income rather than capital gain.
A 1031 exchange defers gain on the disposition of property. It does nothing whatsoever about cancellation of debt. So the worst version of this is an owner with a $200,000 gain, $300,000 of debt forgiveness, and no cash from the sale to pay tax on either.
There are statutory exclusions that may apply, including insolvency, bankruptcy, and an election available for qualified real property business indebtedness which generally reduces basis instead of recognizing income. Whether any of them fits is entirely a question for your CPA, and it should be answered before you agree terms with the lender rather than when the form arrives in January.
An exchange also defers your losses
The quieter problem. If a disposition would produce a genuine loss, an exchange does not let you take it. The loss is folded into the basis of the replacement property instead of being available now.
Deferral is the whole point when you have a gain. Where you have a loss, it is usually the opposite of what you want, and it is a reason we sometimes advise against an exchange entirely, which we set out in when not to do a 1031.
The practical problem on top of all this
Even where an exchange would help with the gain, an underwater sale generally produces no equity. There are no proceeds for the intermediary to hold and nothing to reinvest, so the mechanics have nowhere to start. The debt replacement side is also awkward, which is the arithmetic we covered in mortgage boot.
What to do instead is usually unglamorous: model the gain and the forgiveness together, with your CPA, before negotiating with the lender. Find out whether an exclusion applies. Understand that the lender's reporting and your return need to tell the same story. And treat the exchange question as the last one rather than the first, because on these facts it is rarely the lever that matters.
None of which means an underwater owner has no options. It means the options are tax planning and lender negotiation rather than a like-kind exchange, and that is a different conversation to start early. Your CPA determines the treatment for your specific numbers.
Common questions about underwater property
How can I owe tax when I sold at a loss?
Gain is measured against adjusted basis, not the loan. Depreciation lowers basis over time, so a sale below the mortgage can still exceed basis and produce gain.
Does a 1031 exchange help with forgiven debt?
No. Cancellation of debt income is separate from gain on the disposition, and an exchange defers only the latter.
Are there any exclusions for forgiven debt?
Possibly, including insolvency, bankruptcy, and an election for qualified real property business indebtedness. Whether any applies is a determination for your CPA.
Can I exchange if there is no equity left?
Usually not usefully. With no proceeds there is nothing for the intermediary to hold and nothing to reinvest.
What if I would realize a real loss?
An exchange defers losses as well as gains, folding the loss into the replacement property's basis. That is often the opposite of what you want.
Disclosure: Numerical example is for illustration purposes only; individual circumstances will vary.