Impacts of Seller Financing on IRC Section 1031 Exchanges

A “seller carry back,” a “contract sale” or a “note and trust deed” sale are all terms that describe forms of seller financing. Seller financing can be either an obstacle or an opportunity depending upon one’s situation. Traditional 1031 Exchange thought is that a contract sale will not work in an exchange; this is not true.

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 use the note in the exchange to defer all your taxes. Though a contract sale can be incorporated in an exchange, it may not be possible to accomplish this goal all the time. In order for a note to be used in an exchange, you, the Exchangor, must not have actual or constructive receipt of the note.

When a taxpayor receives a note, he will have tax exposure. Equity Advantage receives exchange inquiries from taxpayers that have received or are about to receive a payoff on a note; it is too late to structure an exchange at this point. If you are contemplating seller financing and an exchange is of interest, it is critical to understand the potential consequences and options available to you.

  1. As the Exchangor, you can direct Equity Advantage to sell the note to a third party, such as a bank, a 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 don’t deposit the additional cash, you will have tax exposure on the difference between the note’s value and the sale price of the note.
  2. 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.
  3. You, the Exchangor, purchase the note from Equity Advantage. The note has now been converted to cash and the exchange can be completed.
  4. 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).

A final consideration is that 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.