Seller Financing in a 1031 Tax-Deferred Exchange

In a sale of real estate, it’s common for the seller, the taxpayer in a 1031 exchange, to receive money down from the buyer in the sale and to carry a note for the additional sum due. The taxpayer facilitates financing for the buyer in this way to make the transaction happen. Sometimes this arrangement is entered into because both parties wish to close, but the buyer’s conventional financing is taking more time than expected. If the buyer can procure the financing from the institutional lender before the taxpayer closes on their replacement property, the note may simply be substituted for cash from the buyer’s loan. Regardless of the circumstance for seller financing, without further steps, the taxpayer’s use of the value of the note toward the purchase of the replacement property will be taxable.

In a non-exchange context there is no problem in the taxpayer carrying back a note from the buyer. However, under the exchange regulations, the actual or constructive receipt of the note would run afoul of like-kind exchange rules. More specifically, as stated in the regulations:

“If the taxpayer actually or constructively receives money or other property in…. consideration for the relinquished property before the taxpayer actually receives like-kind replacement property, the transaction will constitute a sale and not a deferred exchange, even though the taxpayer may ultimately receive like-kind replacement property.”

The taxpayer’s receipt of the note would constitute “other property,” and the amount of the note would constitute “boot” and would be taxable. However, there are two ways to work around this adverse consequence, both of which require the note (and instrument securing the note) to be issued in the name of the qualified intermediary f/b/o taxpayer’s name.

Relinquished Property Buyer’s Note is Used to Purchase Replacement Property

Once issued in the qualified intermediary’s name, the trick then is to use the note or its value to purchase, in whole or in part, the replacement property. Under certain limited circumstances, the seller of the replacement property may be willing to take the note as part of the payment for the replacement property. Typically, the instrument securing the note would also be transferred to the replacement property’s seller. Although not legally required, the taxpayer would typically be expected to add his guaranty to the note to further enhance the third party seller’s degree of security. The third party seller’s receipt of the note would also allow that party to report the gain on the sale on an installment basis which is beneficial assuming that this party is not also doing his or her own exchange. However, in the real world, it is a bit difficult to expect the seller to agree to accept the note as part of the purchase price.

Note Buyout by Taxpayer Prior to Replacement Property Purchase

A solution is for the taxpayer to “buy” or redeem his own note from his exchange account with fresh cash. These funds can be cash that the taxpayer already has available, such as from a home equity line, or it can be from a loan that the taxpayer takes out to buy the note. Essentially, this enables the taxpayer to advance those personal funds into the replacement property even though not receiving the equivalent amount of cash from the buyer at that time. The benefit to the note buyout is that the future principal payments (but not interest) received by the taxpayer over time will be fully tax-deferred.

In the example above, care should be taken during the negotiations with the buyer of the relinquished property to assure that the taxpayer will be receiving sufficient interest on the buyer’s note to offset the costs of any loan taken out by the taxpayer or the time value of the taxpayer’s personal funds used to acquire the note from the qualified intermediary.

The taxpayer and qualified intermediary should also be careful in timing when the note is assigned to the taxpayer. There is a natural tendency to pass the note simultaneously upon receipt by the qualified intermediary of the equivalent amount of cash. After all, the client is putting into the exchange account the exact same value that is being taken out. However, because the regulations prohibit the taxpayer from the “right to receive money or other property” during the pendency of the exchange transaction, it is probably a safer practice to to assign the note to the seller simultaneously with the acquisition of the replacement property or after the replacement property has been acquired. Some qualified intermediaries will provide a form they will sign acknowledging the substitution of cash for the note with a promise to distribute the note upon the closing of the exchange account.