Impacts of Seller Financing on 1031 Exchanges
Sometimes, creativity can either make or break a deal. A contract sale, whether a land sale contract or note and trust deed sale, offers tremendous opportunities to complete a deal. The reasons for a seller-financed transaction can be anything from the seller’s desire to receive payments over many years to a situation where a property or its buyer is simply not able to be financed. Examples of situations where a contract sale can make a deal are:
- The seller of the property simply wants income over time; section 453 of the Internal Revenue Code allows taxes to be paid as payments are received. A contract sale may be a wiser investment choice than a sale for the reason that the seller can usually negotiate a higher interest rate than the bank would pay on deposited funds. If the note is for an 8% interest rate, over the long run the note will pay more than if the seller took the sales proceeds and deposited the money into an interest bearing bank account. You must also consider the money deposited with a bank would net proceeds after paying taxes.
- The buyer cannot attain new financing but is able to acquire financing as a refinance.
- The property may currently be unable to be financed. A short-term contract sale may allow the buyer to make the necessary improvements and then acquire traditional financing from a bank.
- A purchase or sale must happen before permanent financing is available. The seller carry back may be able to close in a much shorter period of time than is required for a new bank loan. The flexibility of closing time may enable deals to be made that are impossible through traditional means.
The seller carry back offers tremendous flexibility in a closing, even when the seller intends to do a tax-deferred exchange.
A "seller carry back," a "contract sale" or a "note and trust deed sale" are all terms that describe forms of seller financing.
Notes and the 1031 Exchange
Since a note typically represents equity in a property and a 1031 Exchange requires all equity to be carried forward to be completely tax deferred, it is necessary to somehow use the note in order to defer all your taxes.
USING THE NOTE
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.
Since the note will most likely be sold at a discounted price, you will need to deposit the cash amount that was discounted on the note. If you do not deposit the additional cash, you will have tax exposure on the difference between the note’s value and the sale price of the note.
- You, the Exchangor, use the note along with the cash to acquire the replacement property. The Seller of the replacement property now owns the note.
- You, the Exchangor, purchase the note from Equity Advantage. The note has now been converted to cash and the exchange can be completed.
- If the note is short-term maturing inside the 180-day exchange period, it is possible to complete the exchange after the note is paid off.
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 then be considered "boot" and payments on the note will receive installment sale treatment (Section 453).
If the note is received as "boot" at the end of the exchange, you may not receive installment sale treatment and therefore taxes may be due on the note’s entire value when the note is received.
A final consideration is that in order for a note to be used in an exchange, you, the Exchangor, must not have actual or constructive receipt of the note. Equity Advantage often receives requests to structure an exchange for a potential client that has been in possession of the note or a note payoff. Equity Advantage is unable to help in this situation as the note must be the Facilitator’s at closing, just as the cash must.