Notes and Seller Financing in a 1031 Exchange (Seller Carrybacks)
Recently we posted an article, 1031 Exchange: Notes & Seller Financing. It isn’t surprising that as predictions of a coming recession are front page news that this was a popular article.
In response, we have put together this video to clarify notes and seller financing in a 1031 Exchange in more detail for you. In the last few years, we’ve seen very few seller carry backs, but as the markets change, we’re going to see more of them, and it’s just one of those big fallacies in the exchange world, you hear it all the time, “Well, you can’t do an exchange and carry paper,” That is just not true, learn how you can!Read the Full Transcript
Hi, David Moore with Equity Advantage, and it is July of 2022, and we’re going to talk about notes in an exchange. Notes seller financing, something that in the crazy market the last few years we haven’t seen much of, but it’s already coming back. So a few things I just want to mention, whether you’re the buyer or seller in an exchange or just if you’re looking at installment sales, a way to be an end game for you, so any time you’re looking at seller finance in a 1031 to sell and carry a note and trust deed is typically problematic. Buying on a note and trust deed is not.
Something to consider if you’re selling carrying paper is, let’s say it’s your end game, let’s say you just decide, “Hey, I’m done, I just want to take it an installment sale, I don’t want to take all the tax at one point in time, I want to take it over let’s say the next 10 years,” first thing you’re going to want to do is make sure you’ve got some type of acceleration provision in the note. Something that makes sure that you’re going to be able to have that 10 years of income that you want, it’s not going to be impacted by somebody selling the property, changing, doing a refi, something like that that will accelerate because one of the biggest issues wit a note is that a lot of times people think, “Well, hey, I’m not getting payments, I’m not getting principal payments, then I don’t have any tax.”
The biggest thing you’ve got to understand is you sell and carry a note, just to do it, you’re looking at tax on debt relief and depreciation recapture in the year of the sale. So if that’s your end game, and I was speaking to a presentation at a investment group a few months ago, and somebody was talking about doing this, and it’s the classic Nothing Down deal, and if you’re old like I am, not that old, but older, let’s say, and you remember a book, Robert Allen’s Nothing Down, I believe it was in the ’70s, one of the first real estate books I ever read, talked about Nothing Down, obviously.
And that’s a great concept, but if you’re the seller, understand what’s going to happen when you close and sell a property, if you’ve got a broker involved, the broker probably wants to get paid, escrow is going to want to get paid. If you’ve got an exchange being structured, I’m going to want to get paid, there are costs that are going to be incurred at closing and you’ve got to have enough money to cover those things, you’re going to be coming out-of-pocket money to cover those things. The other thing that people don’t really think about is, if you’ve got debt on the property that’s being sold, you’re going to have tax on debt relief in the year of sale whether you get a principal payment or not.
The other thing people don’t think about is, if you’ve got a depreciable asset and you’ve taken depreciation on, depreciation will be recaptured in the year of disposition also. So those Nothing Down deals sound wonderful for a buyer, but if you’re a broker representing a seller and they better understand, the seller better understand the repercussions of that Nothing Down deal or they’re going to be very unhappy campers.
Now, furthermore, if we’re looking at doing an exchange, a lot of times you’ll hear people say, “You cannot do an exchange carrying seller finance and no trust at your land sale contract,” it’s totally untrue. It’s just something that’s got to be planned for, and there’s actually a variety of ways that you can do an exchange with a note. Now, look at what happens with any exchange, you’re giving us something, we’ve got to give you something back, and what’s going to receive that would have to be of like kind, you’ve got to go across or up in value and equity, and finally, we’ve got to have continuity investing, just means the person already that gave us something as be given something back. So if you get to, let’s say you did a Nothing Down deal, now you’re thinking, “Well, hey, I didn’t get any principal payments, I don’t have the tax.”
Again, be aware of that stuff, if you’re doing the exchange, that note becomes ours just like cash would at a closing, so to do an exchange and do something, use that note through the transaction to do a deal without tax, that note’s going to be given to the tax, I’m sorry, not the taxpayer, but the exchange company at time of disposition, so just as we would receive cash, we’re going to receive the note, we’ll be the beneficiary of it.
We then have a few options, we can use the note and cash to go buy something. Honestly doesn’t happen very often, the seller of the replacement property doesn’t know you, doesn’t know the property, doesn’t know the other buyer, and really there’s not a lot of motivation for them to take that note along with cash to make a deal happen. The other thing that can happen is you can discount the note and sell to a third party, and you’d think with bank accounts paying what they’re paying and everything else that’s going on, you think maybe a note would be worth something, but it’s my experience lately that the discount on the note can often be an excess of what the tax consequences of just taking it, so that doesn’t happen a whole lot.
Maybe the note’s there because the property is not financeable, so it’s a short-term note. In that situation, we’re just going to wait till the note balloons, and as soon as that balloon payment comes in, we’ve got the cash to complete the transaction tax deferred for the taxpayer once again. The last option, well, actually there’s two more options. Another option that happens most of the time is that the client, our exchange or buys a note from us, and you’re saying, “Well, gee, it’s my note, why would I buy my own note?” And what you’re really doing is substituting cash for the note.
If you’ve got, let’s say it’s a $250,000 note. If you’ve got 250k sitting in the bank today, what kind of money are you getting on it? Virtually nothing. You might have sold the property and now you’re looking at a note that’s paying you 5, 6, 7%. I joke, maybe if it’s in some of these hard money places, it could be up to 20% on it, but that note is going to pay a lot more than money sitting in the bank, so what you’re really doing is substituting cash for the note. It would allow you to complete the transaction totally tax deferred and have the benefit of that installment sale over time, your money is doing something for you once again.
The last option is just do a partial exchange, you’re going to do an exchange on the down payment, and you’re going to have tax exposure on that note as boot received, the tax is going to be paid as you receive the principal payments, capital gains tax will be incurred there, and then you’re going to pay normal income tax on the interest that’s being paid on those payments as well. But if you’re getting out of real estate, a seller carry back and be a great game for you and just food for thought, if you’re doing it for that reason, as I said, one, make sure you understand any tax repercussions, what it’s actually going to cost you to close the deal, and whether you’ve got tax repercussions on debt relief or depreciation recapture, make sure you cover those things.
And you better, like I said, have an acceleration provision in there ensuring that it’s going to go forward. We get a lot of calls after somebody’s sold on a known trust deed and then a year or two years, three years later, also the balloon payments coming in, and the taxpayer wants to do an exchange at that time. It’s too late, we can’t. The sale already happened, it’s just a question when you’re going to incur the tax, because you are going to incur the tax on that note and trust deed or land sale contract.
Another consideration, obviously, is the buyer’s default, what happens if that buyer defaults, what happens to you, you’re going to end up getting the property back really throughout… I’ve been doing this for 32 years. I think we had one client that sold the same property three different times, three different defaults, three different exchanges, so pretty crazy in that scenario. But if you’re looking at some way to do that installment sale, couple other options you might consider is a structured sale, they evolved out of the structured settlement world, and basically a third-party assignment company comes in and assumes the obligation to pay, and the great thing about those is, you can structure the deal to your liking, you can have the pay out over whatever period of time you want. So once again, you’ve got a third party that’s basically assuming the obligation to make those payments, and they do it. The benefit of it is, you do it over the time period you want and don’t worry about the buyers default.
The ultimate installment sale in my opinion, is it’s really an up REIT, and an up REIT just for the sake of this presentation, this is a five-minute talk, is really a situation where you’re doing an exchange, typically these up REITs are structured by companies that sell DSTs, Delaware Statutory Trust, you’re going to buy into one of their offerings, and then at a later date that DST interest ends up being converted to shares of a REIT. And there’s no tax on that conversion and you ultimately, you’re going to pay tax as you sell shares of the REIT, so it’s the ultimate installment say, sale I say, because you don’t have to have a predetermined set of period of time that you’ve got this to happen, it’s just going to happen as you choose to sell the shares and make those payments.
The downside, there’s always a downside. It’s a stock, the REIT shares could go up and down in value and that’s going to impact your ultimate return on investment, but there’s an explanation of different options you’ve got, different ways to use the note and trust deed, your land sale contract, seller finance. Now, as I said, if you want to buy and have somebody carry you, that’s great, that does not impact your exchange at all, it’s only if you’re selling and carrying note that it does.
Now, one last comment I want to make with seller finance. Let’s say that you’re doing a reverse exchange with us, now you go out, and we’ve got another video on YouTube talking about reverses and notes, but I’m just going to hit it real quickly. In a reverse exchange, you’ve got to have the financial ability to buy a property, the day to replace something yet to be sold. Now, if you enter into that transaction with us, whatever money is needed to make that purchase is going to be loaned to us, loaned to the exchange company Equity Advantage, and we’re going to have a debt that’s going to be repaid to you when your property sells in the future.
Now, think about this, does it matter whether that’s cash on that future sale or a note? We can take the note, you can do a seller carry back on the property that goes away and use that note as consideration. We end up getting that note at settlement, we can use that note to repay the debt we’ve got to you and you could then once again have the benefit of the installment sale. So let me say that one more time. So in a reverse exchange, you’re going to show up the purchase and replacement, you relinquish property as enclosed it, you’re going to show up to the purchase replacement with whatever’s monies needed to close on that deal, we sign a note saying we’ve borrowed that money from you.
When your property sells in the future, whatever the proceeds are going to be used by us to repay that debt, because when that property sells just as any exchange, it’s going to come to us, we sell, the proceeds are ours, we can then use that note to repay the debt we have to you. So, in a reverse exchange, a seller carry back on the relinquished property isn’t a problem, it’s just if you’re trying to do a regular delayed exchange and you carry the paper, that’s where the issue is.
I hope this has clarified the issue a little bit for you, as I said, it’s July of 2022, the last few years, we’ve seen very few seller carry backs, but I would expect as the markets change, we’re going to see more of them, and it’s just one of those big fallacies in the exchange world, you hear it all the time, “Well, you can’t do an exchange and carry paper,” you can, there’s five different ways to do it. Once again, David Moore, Equity Advantage, 1031exchange.com, thank you for coming to spend your time with us and learn a little bit. Take care, bye bye.
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