Real estate owners sometimes decide to do seller financing and act as the bank when selling a property. Instead of receiving all cash at closing, the seller carries a note, often called a land sale contract or trust deed note. While this approach can make a deal easier to complete, it can also create unexpected tax consequences. David Moore, co-founder and CEO of Equity Advantage, raises this issue directly by asking what options exist for someone who plans to carry a note as part of a sale.
Tom Moore, co-founder and President of Equity Advantage, explains that the tax outcome depends on how the transaction is structured and whether the seller is attempting a 1031 Exchange. His explanation highlights an important distinction many sellers overlook.
A Carried Note Is Not Like-Kind Real Estate: the Downsides of Seller Financing
Tom Moore points out that if you act as the bank and receive a note at closing, that note is not considered like-kind real estate. In the context of a 1031 Exchange, this matters a great deal. Only real estate qualifies for tax deferral. A note does not.
Because the note is not like-kind property, it becomes taxable boot. Boot is anything received in an Exchange that does not qualify for deferral. Once boot appears in the transaction, some level of tax becomes unavoidable.
This is where many sellers get caught off guard. They assume that because the note is tied to a real estate sale, it will receive the same tax treatment. According to Tom Moore, that assumption is incorrect.
Installment Sale Treatment Comes Into Play
When a seller carries a note, the transaction typically falls under installment sale treatment. This means the tax is not always due all at once, but it is still very real.
Tom Moore explains that if you receive a down payment along with the note, that down payment is taxed in the year the sale occurs if you are not completing a 1031 Exchange. The note itself does not eliminate tax. It only spreads the timing of when the tax is paid.
As payments are received over time, each payment carries tax consequences. This is where understanding how the payments are broken down becomes critical.
How Principal and Interest Are Taxed
Tom Moore clearly separates the tax treatment of principal and interest. Principal payments on the note are taxed as capital gains. This reflects the gain from the sale of the property itself.
Interest payments, however, are taxed as ordinary income. This distinction is important because ordinary income is often taxed at a higher rate than capital gains. Sellers who rely on monthly or annual note payments need to account for this difference when planning cash flow.
In many cases, a note is structured with interest payments over time and a balloon payment in the future. During the period when interest payments are received, the seller reports ordinary income. When the balloon payment arrives, the principal portion is taxed as capital gains.
Why This Matters for 1031 Exchange Planning
David Moore’s original question highlights a common planning issue. Sellers may believe they are preserving flexibility or income by carrying a note, but they may unintentionally undermine their ability to fully defer taxes through a 1031 Exchange.
Once a note is introduced into the transaction, the seller is no longer receiving only like-kind real estate. That note becomes boot, triggering tax exposure. Even if the Exchange is otherwise structured correctly, the presence of a note changes the outcome.
Tom Moore’s explanation shows that the issue is not about whether carrying a note is allowed. It is about understanding the tax result and making an informed decision.
Planning Before Closing Makes the Difference
The key takeaway from David Moore and Tom Moore is that these decisions must be evaluated before the sale closes. Once the transaction is completed and the note is in place, the tax treatment is already determined.
Sellers who want to act as the bank need to understand that they are also accepting installment sale taxation. Capital gains on principal and ordinary income on interest are built into the structure.
If you are considering carrying a note as part of a sale and are also thinking about a 1031 Exchange, the safest step is to review your options with an Exchange expert before you sign closing documents. To understand how notes, boot, and installment sales affect your situation, contact Equity Advantage to speak with an Exchange expert who can walk through your specific transaction.
The Guys With All The Answers…
David and Thomas Moore, the co-founders of Equity Advantage & IRA Advantage
Whether working through a 1031 Exchange with Equity Advantage, acquiring real estate with an IRA through IRA Advantage or listing investment property through our Post 1031 property listing site, we are here to help Investors get where they want to be. Call them today! 503-635-1031.
