Seller Financing and 1031 Exchanges

A Brief Introduction to Seller Financing

When a market shift causes interest rates to rise, sellers may offer to finance a portion of their purchase price to incite and motivate buyers. At closing, the buyer would pay a portion in cash, and sign a seller-funded note (sometimes referred to as an “installment note,” wherein the buyer pays back the note in installments) for the balance.
If a seller of investment real estate carries back an installment note from the buyer, generally the IRS does not tax the full value of the note when it is received, but instead taxes each installment payment as income attributable to the tax year in which the installment is received. Per IRC §453 – “Installment Method,” the principal portion of each payment is taxed subject to capital gains rules and the interest portion is taxed as ordinary income. Therefore, accounting for the note payments using the installment method can help provide a temporary deferral of recognition of capital gains and can help mitigate the impact of a large tax liability.

Installment Notes and 1031 Exchange Scenarios

Is it possible to transact a 1031 exchange if the buyer uses both cash and seller financing to purchase the relinquished property from an Exchanger?

Yes. The Exchanger has two options:

  1. Combination §1031 exchange / §453 installment sale: Include only the net cash proceeds in the 1031 exchange (to the extent such proceeds exceed one’s adjusted basis- taxpayer should discuss with their tax advisor) and take possession of the note at the time of sale. In this scenario the Exchanger would be able to indefinitely defer the capital gain attributable to the cash that is reinvested in replacement real estate. By taking the note at sale, the Exchange elects to receive installments pursuant to the terms of the note. These payments will be taxed under the installment method of reporting discussed above.
  2. Full §1031 exchange: Include both the note and the cash proceeds in the 1031 exchange. To accomplish this, the note must be made payable to the Qualified Intermediary (“QI”) at the relinquished property closing. The QI will receive all payments on the note, including interest, which can be used by the Exchanger as part of the consideration to acquire the replacement property. During the exchange period, the note can either be converted to cash (through the sale and assignment of the note to the Exchanger or third party) or it can be used as part of the consideration to purchase replacement real estate during the 180-day exchange period.

A common misperception by investors is that they will be able to utilize a 1031 exchange on a lump sum payment years after the original sale. Such a theory is flawed; the note must be utilized in the exchange using one of the following methods:

  1. The Exchanger contributes cash to liquidate the note. The Exchanger would buy the note back from the QI for face value through an assignment of the note. The purchase price paid by the Exchanger will be added to the exchange value and applied toward the acquisition of the replacement property as part of the exchange proceeds. The Exchanger would treat future principal payments on the note as return of basis since they acquired the note at face value. The Exchanger will pay income tax on the interest on the note as they receive it.
  2. Sell the note to a third-party buyer for cash. The marketability of the new note can vary on a case-by-case basis, however, if an exchanger can arrange for a third-party to purchase the note, then the proceeds from the purchased note can go directly to the QI and be added to the exchange proceeds. A third-party buyer of the note will typically look for a discount to the face value.
  3. Bridge financing/short-term financing. Sometimes the buyer of the relinquished property encounters a delay in obtaining financing and the seller needs to proceed with a sale. The buyer can obtain a “short term” note from the seller and later satisfy the note by making a payment to the QI; the payment must be made within the exchange period and prior to the acquisition of the replacement property. The QI will hold the proceeds in escrow and sign a release and satisfaction of the note on behalf of the Exchanger. Once the note is fully satisfied, the note value becomes part of the exchange proceeds and can be used to purchase replacement property just like your typical replacement property purchase.
  4. Use the note itself as part of the consideration to acquire the 1031 replacement property. As part of the purchase, the seller can agree to assume/take over the note from the exchanger, thereby making the note part of the new property purchase. As a practical matter, this rarely happens.

Legal 1031 Exchange Services LLC does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of any transaction. Taxpayers must consult their tax and/or legal advisors for this information. Unless otherwise expressly indicated, any perceived federal tax advice contained in this article/communication, including attachments and enclosures, is not intended, or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.
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