1031 Exchange: Notes & Reverse Financing

In recessionary times seller finance gets more common. It has often been said that you cannot do an exchange while carrying a note, this is not true. Please note if seller finance is an End Game for you, there is tax exposure on debt relief and depreciation recapture in the year of disposition whether you receive a principle payment or not.

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 use the note in the exchange if you intend to defer all your taxes. You have several options available to incorporate the note in the exchange.

USING THE NOTE

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 at the Facilitator’s at closing just as the cash must.

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 or 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.

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).

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.

Consult your tax and legal counsel regarding the transaction.

Learn More About the Impact of Seller Financing

Navigating 1031 exchange options takes a professional, and you can count on the whole team at Equity Advantage to help. Your investments are just too important not to have an expert on you team. Give the folks at Equity Advantage a call, 503-635-1031, to get started!