Seller financing can be a powerful tool for getting a commercial real estate transaction across the finish line.
A buyer may have the equity and experience necessary to acquire a property but may not want, or may not be able, to obtain conventional financing on acceptable terms. In that situation, a motivated seller may agree to finance a portion of the purchase price through a promissory note, commonly referred to as a seller carryback note.
But what happens when that seller also wants to complete a 1031 Exchange?
As a matter of fact, a property owner can provide seller financing and still complete a 1031 Exchange. However, not only must the note be structured correctly from the beginning, but the Qualified Intermediary (QI) also needs to know the structure before opening the exchange file.
The way the note is written, who receives it at closing, and how it will ultimately be used can determine whether the seller achieves full tax deferral, partial tax deferral, or an unexpected taxable event.
This is exactly why I continually emphasize one rule above all others:
Plan First!
The First Decision: Is the Note Inside or Outside the Exchange?
When seller financing is involved, the exchanging taxpayer must decide whether the carryback note will remain outside the exchange or become part of the exchange proceeds.
That decision cannot be made after closing. It must be addressed before the relinquished property is transferred and before the note is issued.
Keeping the Note Outside the Exchange
When the carryback note remains outside the exchange, it is generally made payable directly to the seller and delivered to the seller at closing. The cash portion of the sale proceeds is transferred to the seller’s Qualified Intermediary (QI) for use in purchasing replacement property.
Because the seller receives the note rather than like-kind real estate, the note is not tax deferred under Section 1031. It may, however, qualify for installment sale reporting under Section 453.
Which highlights why your CPA must also be engaged as early as possible in the initial planning stages.
When installment treatment applies, the taxable gain associated with the note may be recognized over time as principal payments are received rather than entirely in the year of sale. Interest is generally reported separately as interest income.
However, investors need to understand that not every part of the gain necessarily qualifies for installment treatment. Special rules may apply to depreciation recapture, related-party transactions, and notes that do not provide adequate stated interest.
Keeping the note outside the exchange may make sense when the seller:
- Wants continuing income from the buyer.
- Is comfortable completing a partial exchange.
- Has enough cash proceeds to acquire suitable replacement property.
- Is willing to recognize some taxable gain over time.
This can be a perfectly legitimate strategy. A 1031 Exchange does not have to be an all-or-nothing transaction.
Including the Seller Carryback Note in the Exchange
An investor seeking the greatest possible tax deferral may instead attempt to include the seller carryback note in the exchange.
This requires careful coordination before the relinquished property closes. The note generally must be made payable to the QI, not directly to the seller.
The taxpayer cannot first receive the note and later decide to place it into the exchange. Receiving or controlling the note may cause it to be treated as taxable non-like-kind property, commonly referred to as boot.
Once the QI holds the note, the note must somehow be converted into value that can be applied toward the purchase of replacement property. There are several potential strategies.
Option One: The Buyer Pays Off the Note During the Exchange
A short-term note may be structured to mature before the replacement property must close.
Payments are made directly to the QI, and the resulting cash becomes part of the exchange proceeds available for the replacement property acquisition.
This can work, but the timing must be precise.
The replacement property generally must be identified within 45 days and acquired within 180 days of the relinquished property transfer, or by the applicable tax return due date, including extensions, if earlier.
If the note is not paid in time, the expected funds may not be available for the replacement property closing.
Option Two: A Third Party Purchases the Note
An unrelated note buyer may purchase the carryback note from the QI.
The QI assigns the note to the third-party purchaser, receives cash in return, and applies that cash toward the replacement property.
Of course, a note buyer may discount the note based on factors such as:
- The interest rate.
- The term of the loan.
- The payment schedule.
- The underlying collateral.
- The creditworthiness of the borrower.
- The loan-to-value ratio.
A $500,000 promissory note does not necessarily have a cash market value of $500,000. That potential discount needs to be understood before the seller commits to the structure.
Option Three: The Exchanger Purchases the Note
In some transactions, the exchanging taxpayer may use separate, non-exchange funds to purchase the note from the QI.
The QI receives the taxpayer’s cash and uses it to acquire the replacement property. The taxpayer then receives the promissory note as a separate investment outside the exchange.
This strategy may provide the cash necessary to complete the exchange while allowing the investor to retain the income-producing note.
However, it must be carefully coordinated with the QI and the taxpayer’s independent tax and legal advisors. This is not something that should be improvised at the closing table.
Option Four: The Replacement Property Seller Accepts the Note
The seller of the replacement property may agree to accept an assignment of the carryback note as full or partial payment for the property.
Although this is possible, it is not especially common.
The replacement property seller must be willing to evaluate the note, the borrower, and the underlying collateral rather than receive all cash at closing. The seller may also require additional security, a discount, or other protections before agreeing to accept the note.
This option requires creativity, cooperation, and considerable advance planning.
What About a Separate Hard Money Loan?
Another possibility is for the relinquished property seller to act as a separate lender and advance cash into escrow for the buyer.
The buyer uses those loan proceeds to purchase the relinquished property, and the closing escrow transfers the seller’s sale proceeds to the QI.
Mechanically, this may be simpler because the QI receives cash rather than a promissory note.
However, the seller needs to carefully evaluate the risk.
If the exchange fails, cash eventually distributed by the QI may trigger immediate recognition of taxable gain. By contrast, if the QI holds a carryback note and the exchange fails, the note may be assigned back to the taxpayer, potentially preserving installment sale reporting for eligible gain.
The correct structure depends upon the investor’s objectives, available liquidity, tolerance for risk, and confidence that the exchange will be completed.
Seller Financing Does Not Have to Kill the Exchange
The important takeaway is that seller financing and a 1031 Exchange are not mutually exclusive.
A carefully planned seller carryback can help a buyer complete the acquisition while allowing the seller to pursue a replacement property strategy.
But the structure must be selected before closing.
The seller, commercial real estate broker, Qualified Intermediary, CPA, tax attorney, escrow officer, and lender all need to understand the plan. The note itself should also address adequate interest, collateral, default remedies, payment timing, personal guarantees when appropriate, and the buyer’s ability to repay the obligation.
A seller should never provide financing merely to save a weak transaction. The note is only as strong as the borrower, the collateral, and the legal documents supporting it.
When seller financing is considered as part of an exchange, that planning should begin before the listing agreement is finalized whenever possible.
A 1031 Exchange involving a seller carryback note can be completed successfully. It simply requires the right structure, the right team, and a well-developed plan established long before closing.
Plan First. Exchange Successfully.
We Are Here to Help!
If you are an investment property owner, schedule a no-obligation strategy call at www.Best1031Online.com, or contact James Bean of SVN-Rich Investment Real Estate Partners (CA DRE# 01970580) at 805-779-1031 or james.bean@svn.com.
If you are an agent or broker, I am happy to discuss strategies on how to best serve your next listing client in preparing them for a successful exchange. Visit the website and click the Agent’s button in the top right corner of the homepage.
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This article is intended for educational purposes only and should not be considered tax, legal, lending, or financial advice. Every transaction is different. Property owners should consult their own qualified tax and legal advisors and engage an experienced Qualified Intermediary before structuring the sale or exchange.
The post Can You Use Seller Financing in a 1031 Exchange? appeared first on Preserve Your Wealth in CRE.