ALSO SEE
Seller Carryback
Regulations were issued April 20, 1994, to coordinate certain aspects of § 1031 and § 453. Reg. § 1.1031(k)-1(j)(2); Temp Reg 15a.453-1(b)(3).
Section 453 applies to a transaction where the seller receives payments over more than one tax year. Rather than forcing the seller to recognize (i.e., pay taxes on) all of the gain in the year of sale, § 453 allows the Taxpayer to recognize portions of the gain in the years the payments are actually received.
Gain is computed according to the percentage of gross profit received in each year. Generally speaking, the gross profit (sales price less basis) is divided by the sales price, to determine the percentage of each year's principal payments which will be subject to capital gains tax.
Under § 453, the installment note must be received from someone who is "acquiring the property" from the Taxpayer. What happens if the Taxpayer receives the note from the Qualified Intermediary (QI), instead of from the buyer the Regulations solve that problem, by providing that the receipt of the note from the QI will be treated as having been received from the person acquiring the property.
A Taxpayer wishes to enter into a § 1031 exchange, to defer a portion of the gain on the sale of relinquished property, and would also like to take back a note and trust deed in partial payment of the purchase price. The note will be treated as taxable cash boot, which may not be netted against mortgage boot.
Payments secured by cash or cash equivalents held in escrow accounts will not be deemed to be current payments and thus not taxable currently. 1.1031(k)-1(j)(2)(i). The QI is not treated as an agent of the Taxpayer, thus eliminating the chance that the QI's receipt of the note would be taxed as a current payment. 1.1031(k)-1(j)(2)(ii). Notes distributed to the Taxpayer after the exchange period will receive installment treatment. 1.1031(k)-1(j)(2)(iii).
EXAMPLE: Taxpayer enters into an exchange agreement with a Qualified Intermediary for relinquished property that closed in November, 2007. The sales price is $100,000. Cash proceeds are $80,000 and the buyer gives a note for $20,000. The QI holds the note until the exchange period ends. Before the exchange period ends in 2008, the QI arranges for the purchase of replacement property worth $80,000. At the end of the exchange period the QI delivers the promissory note and assignment of trust deed to the Taxpayer. The Taxpayer does not recognize any gain in 2007. When the Taxpayer receives payments on the installment obligation, he will pay tax on the principal received.
The regulations allow installment treatment not only for installment obligations received at the end of the exchange period, but also for the entire consideration, in the event that the exchange fails entirely. Christensen v. Commissioner, T.C. Memo 1996-254 71 TCM 3137
EXAMPLE: Taxpayer enters into an exchange agreement with a QI in November 2007. Taxpayer has a bona fide intent to complete the exchange into like-kind property. Under the agreement, the QI transfers the relinquished property worth $100,000 and a basis of $40,000 to a buyer and receives cash of $100,000. Taxpayer enters into an agreement to purchase replacement property, subject to a contingency over which the Taxpayer has no control. The contingency is not satisfied and no other replacement property was identified by the Taxpayer. At the end of the exchange period, in 2008, the QI delivers to the Taxpayer $100,000 in cash. The Taxpayer recognizes gain of $60,000 and pays the tax in 2008, when the cash is received from the QI.
See: Smalley v. Comm, 116 T.C. No. 29. Taxpayer's actions demonstrated sufficient intent to complete an exchange, even if the underlying property may ultimately be found to be "non-qualifying".
Alternate methods for structuring the installment note
The Taxpayer can take delivery of the installment note at the time the relinquished property is sold: The note should be treated as cash boot to be received by the Taxpayer. The assignment of the Taxpayer's position to the QI should specify that the note is not to be included in the proceeds of sale delivered to the QI. The note and trust deed should be drawn in favor of the Taxpayer, not the QI. The note will be treated according to the installment sale rules of Section 453. The installment note will be delivered to the Taxpayer at the time the relinquished property is sold (although delivery may occur at a later date). The note and trust deed/mortgage can be drawn in favor of the QI: The installment note will be treated like cash. The QI will collect the payments. The exchange equity will be increased by the amount applied to principal payments. The interest payments credited to the Taxpayer will be taxed as ordinary income. (This analysis also applies if the note is paid in full during the exchange period.) At the end of the exchange period, the QI will assign the note to the Taxpayer if the note has not been paid in full. The note will be treated as taxable boot, but the subsequent gain will be reported under the installment method.
The installment note can be sold to a third-party for cash: The proceeds increase the exchange equity and can be used toward the purchase of the replacement property. Alternatively, the note can be negotiated to the seller of the replacement property, as part of the consideration for that transaction. [If the note is discounted, the treatment of any discount is uncertain. One possibility is to treat the discount as an expense of the exchange. Taxpayers contemplating a sale of the note at a discount should seek a written opinion from their CPA or tax attorney.]
The Taxpayer can purchase the installment note from the QI. The transaction must be made at arms' length, on commercially reasonable terms. It is advisable not to discount the note. Full payment should be made in cash. This transaction should take place at the same time as the closing on the replacement property. This will avoid any questions of constructive receipt of money or other property by the Taxpayer, prior to the end of the exchange period. In the hands of the Taxpayer the note would be treated as a separate asset, unrelated to the exchange. The Taxpayer's basis would be the cash the Taxpayer paid for the note. The cash payment for the note increases the exchange equity available for the purchase of the replacement property.
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