Seller Financing Strategies and 1031 Exchanges
Seller financing is on the rise. As interest rates stay elevated and buyers find it more challenging (or less desirable) to secure third party financing, motivated sellers can finance a portion of the purchase price for them. At the closing, the buyer deposits the agreed-upon down payment and signs a promissory note to the seller (referred to as a “seller carryback note”, or “note”) for the balance. If structured as an installment sale under IRC Section 453, the seller pays tax on any gain from the sale over time, as the payments on the note are received, rather than paying tax on the gain in its entirety in the year of sale.
If an investor is contemplating a tax deferred exchange under IRC § 1031 and plans to provide financing to their buyer, they must decide how to handle the seller carryback note. The note can either be kept outside of the exchange or, under the conditions described below, an exchanging taxpayer can include the note in their exchange and defer all gains from their sale.
IF THE NOTE IS NOT INCLUDED IN THE EXCHANGE
In many exchanges involving seller carryback financing the note is not included in the 1031 exchange. In such cases the note is taxable boot, but the tax is paid over time, as payments on the note are received. The taxpayer may receive enough cash from the sale that it is still worth sending those funds to the qualified intermediary (or “QI”) to defer a portion of the gain, while still paying some taxes.
When the note is not made part of the exchange, it is made payable to the seller and delivered directly to the seller at the time of closing. Only any cash proceeds from the sale are delivered to the seller’s QI.
NOTE IS INCLUDED IN THE EXCHANGE
If an investor wants to defer all gains in their 1031 exchange, they have a few options to consider. In each case, the note is made payable to the QI directly at the relinquished property closing – this prevents the investor from constructively receiving the note for income tax purposes, which would immediately render the note taxable boot. The QI collects any note payments made during the exchange, which become part of the exchange proceeds.
In order for the note to be used for the purchase of replacement property, it must either be converted to cash prior to the replacement property closing; or, the seller of the replacement property must agree to accept the note as full or partial payment for the property (this is somewhat rare).
Note Converted to Cash
There are three ways that a note can be converted to cash during an investor’s exchange. The first is when the note is a short term note that matures prior to the time the investor must close on their replacement property. Any note payments and the final payoff balance are paid directly to the QI by the borrower during the exchange period. The cash is then used for the replacement property purchase. The timing must be precise, however – all necessary payments must be received prior to the time the replacement property must close.
Another option is for the investor to arrange for an unrelated third party to purchase the note. The QI, as beneficiary, assigns the note to the third party note buyer, and the note purchase funds come to the QI as exchange proceeds. The QI then uses those proceeds to buy the replacement property.
An exchanging investor could also purchase the note from the QI themselves. The QI assigns the note to the investor and uses the note purchase funds as exchange proceeds to purchase the replacement property. The purchase funds for the note can either be directly advanced to the QI or deposited directly into the replacement property escrow by the Exchangor.
Use the Note to Purchase Replacement Property
Occasionally, an investor can negotiate assigning the note to the seller of the replacement property as partial or full payment towards the purchase price. The seller of the replacement property, depending on the market and their own goals in selling, may or may not find this to be an attractive offer. In any case, because it requires both the buyer and seller to be open to such a specific arrangement, this does not occur often. When it does, the QI directly assigns the note to the seller of the replacement property at the replacement property closing.
HARD MONEY LOANS
Some sellers elect to lend the money to the buyer of the relinquished property upfront as a “hard money loan” rather than through seller carryback financing. Using this option, the seller acts as a third-party lender and deposits cash in the amount of the loan into escrow. The buyer uses the loan funds to acquire the property, and then escrow delivers those funds to the QI for use in the exchange. While this is mechanically a smoother and easier process, it is important to consider the likelihood that the investor can complete their exchange. When they make a hard money loan to the buyer, those funds come to the QI, and if the exchange fails, taxes are owed on the cash boot in its entirety (up to the total amount of gains). If, by contrast, a QI is given the note at the relinquished property closing and the taxpayer’s exchange fails, the QI will assign the note back to the taxpayer. The taxpayer will then pay taxes on their gain as they receive payments on the note, as opposed to all at once.
CONCLUSION
If an investor is highly motivated to sell and wants to exchange, there is no reason that providing seller financing to the buyer should prevent an exchange from occurring, or prevent a taxpayer from obtaining the full possible deferral of capital gains. Successfully including a seller carryback note in an exchange requires either some outside cash from the taxpayer themselves or a third party note buyer, a short loan term that will conclude within a 180-day exchange period and before the replacement property closing, or creative negotiations with the seller of the intended replacement property allowing the note to be used for its purchase. It’s important for any taxpayer interested in including a seller carryback note in their exchange to carefully examine all the options and consult with their independent tax and legal advisors, as well as their Exchange Officer, prior to setting up the transaction.
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