Seller Finance and the 1031 Exchange
I once was in attendance of an investment real estate marketing session where a broker proclaimed that seller financing was not something to ever take part in. We at Equity Advantage look at seller financing as an opportunity.
Seller Finance can be utilized for a variety of reasons, the motive of both the buyer and seller is important to consider:
- The seller wishes an income stream over time for retirement.
- The seller would like to spread the tax exposure of the sale over time.
- The property is not currently financeable.
- It is necessary to close the sale before financing is available.
- The buyer intends to flip the property and only needs short-term financing.
It is essential both parties understand the terms of the contract and they should have their respective legal counsel's approval before consummating any note; we have seen many occasions where the buyer or seller did not fully understand the full terms of what was signed. Along with the opportunities, come obstacles and traditionally a tax-deferred exchange was thought to be one of them.
In today's economic environment the use of seller financing may be necessary in order to merely sell a property. A common misunderstanding of installment sales is their impact on a tax-deferred exchange. Many investors are under the impression it is not possible to provide seller financing and still satisfy an exchange, this is simply not true.
Since a note typically represents equity in a property and a 1031 Exchange requires all equity to be carried forward in order to be completely tax deferred, it is necessary to somehow use the note in the exchange. In order for a note to be used in an exchange, the Exchangor must not have had actual or constructive receipt of the note. The note must be held by the Facilitator at the close of escrow just as any cash must be.
The following are options available to you:
- As the Exchangor, you can direct Equity Advantage to sell the note to a third party such as a bank, pension fund manager or a private investor. The proceeds from the sale of the note are then deposited with Equity Advantage. You will need to deposit additional cash to offset the amount that was discounted on the note for total tax deferral. If the additional cash is not deposited, you will have tax exposure on the difference between the note's value and the discounted sale price of the note if any.
- The Exchangor can use the note along with the cash to acquire the replacement property. The Seller of the replacement property now owns the note.
- The Exchangor can also purchase the note from Equity Advantage. The note has now been converted to cash and the exchange can be completed. The Exchangor now benefits from the interest generated by the note, yet does not have a capital gains tax exposure to the gain the note once represented.
- If the note is short term and matures inside the 180-day exchange period, it is possible to complete the exchange after the note is paid off.
- Finally, if you are not concerned with deferring all of your taxes, you may choose a partial exchange, using only the cash proceeds in the exchange. The note will be considered "boot" and payments will receive installment sale treatment (Section 453). Depreciation recapture is due in the year the sale occurred.
Equity Advantage often receives requests to structure an exchange for a potential client that is about to receive a balloon payoff of a note they have been in receipt of. Unfortunately the taxpayor has had receipt of the note and therefore a future balloon payment will be fully taxable.
Understanding the motivation behind the sale and the use of the note often dictates the appropriate option to be utilized. A careful review of the choices available and their respective tax consequences is critical, the taxpayor's tax and legal counsel will be able to make the right decision given the time and information. Seller financing in today's world can be just the tool to help you make that next deal.
