Navigating a 1031 Exchange in a Bankruptcy Situation

1031 exchanges are complex transactions that can offer tax deferral opportunities for investors seeking to reposition into new real estate sectors. The process is governed by strict rules and timelines—and when bankruptcy enters the picture, those layers of complexity increase.

Can a like-kind swap still be possible during or after filing for bankruptcy? Yes, you can still conduct a 1031 exchange, but the process becomes even more intricate than a regular swap.

Below, Realized 1031 has shared an article providing an overview of how such a scenario might play out. Keep reading to discover the process of navigating a 1031 exchange in bankruptcy situations.

Recap of a 1031 Exchange

A 1031 exchange is a transaction in which an investor sells a qualifying property and reinvests the proceeds into another like-kind property. When structured in compliance with IRS rules, the exchange may qualify for nonrecognition of gain or loss, allowing the deferral of capital gains taxes and he potential to preserve more equity in the reinvested asset.

What Constitutes a Bankruptcy?

Those unfamiliar with bankruptcy in the context of investing may simply think of this term as having no money to pay debts. However, bankruptcy takes on a more formal meaning in the investment discourse. Bankruptcy is a legal process that allows an investor or entity to seek relief through the liquidation of their assets or other court-approved payment plans.

Bankruptcy, whether Chapter 7 (liquidation) or Chapter 11 (reorganization), creates an estate composed of the debtor’s assets. A trustee or debtor-in-possession is responsible for managing or liquidating those assets to satisfy creditor claims. Once a property is included in the bankruptcy process, selling or exchanging it often requires court approval and must comply with bankruptcy rules.

Is a 1301 Exchange Still Possible During a Bankruptcy?

Yes, but the process is complex due to various issues you’ll need to address first.

Who Is the Owner?

The first challenge to address is knowing who the owner of the property is. When you file for bankruptcy, all your assets generally become part of the bankruptcy estate. These include real estate investments. As such, you won’t have full control over the real estate asset and cannot sell it without the court’s permission.

• In a Chapter 7 bankruptcy, the trustee may choose to liquidate a property (through avenues like a 1031 exchange) if they believe that it will yield more value.
• For Chapter 11 bankruptcies, the debtor can gain control of the property and, with court approval, sell it through a like-kind swap as part of the reorganization plan. As such, this is only the type of bankruptcy where you have some level of control over the exchange. If it’s a Chapter 7 bankruptcy, the trustee is fully in charge.

Does the Court Approve of the Exchange?

The primary objective of bankruptcy courts is to maximize the value of the estate to pay creditors. The courts may recognize 1031 exchanges as a possible way to increase the value of the estate or provide income for the creditors. Under these circumstances, they may allow the trustee or debtor to proceed with the exchange. In such cases, the trustee or debtor must demonstrate that a 1031 exchange offers more value than a direct sale, in line with the goals of the bankruptcy process.

Considerations When Conducting an Exchange During a Bankruptcy

Conducting a 1031 exchange during a bankruptcy is no different than a regular exchange. The most critical step for this scenario is ensuring that the bankruptcy court approves the transaction. Below are other important considerations to help ensure the exchange remains compliant with IRS regulations:

• 180-day Timeline: The entire exchange must happen within 180 days, with the first 45 days dedicated to identifying the replacement properties.

• Qualified Intermediary: Working with a qualified intermediary is critical to ensure that you don’t have direct control of the 1031 exchange funds from the property sale.

• Fraudulent Transfers: Transactions that appear to benefit the debtor unfairly or harm creditors could be challenged as fraudulent conveyances. As such, it’s important that you demonstrate how the exchange can contribute to the benefit of the estate.

Wrapping Up: 1031 Exchange Bankruptcy Considerations

A 1031 exchange is possible during bankruptcy, but the extra effort needed means you should proceed with caution. The process involves significant legal, tax, and administrative coordination—and often requires collaboration among tax professionals, bankruptcy courts, and creditors. When appropriately executed, a 1031 exchange in bankruptcy may serve as one component of a broader financial restructuring strategy. 

The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.

Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.

Sources:

https://turbotax.intuit.com/tax-tips/investments-and-taxes/1031-exchange-how-it-works/c998pvsTp

https://www.investopedia.com/terms/b/bankruptcy.asp

https://www.uscourts.gov/court-programs/bankruptcy/bankruptcy-basics/chapter-7-bankruptcy-basics

https://www.uscourts.gov/court-programs/bankruptcy/bankruptcy-basics/chapter-11-bankruptcy-basics