As interest rates rise and qualifying for a loan becomes more difficult, it is more common for sellers to provide financing options to buyers – typically by accepting a lump-sum down-payment for a portion of the property’s sale price upfront and carrying a note for the remaining balance. This arrangement, known as seller financing or owner-carry financing, is sometimes used by buyers who wish to avoid involving a financial institution in their purchase transaction.
It may also be used to expedite the sale, allowing the buyer to close on the property quickly without having to wait for loan approval. In this case, the buyer may pay off the seller’s note once they have secured traditional financing.
Sellers may also offer buyers the option to repay the loan over time through a variation of seller financing called an installment sale.
In this blog we will highlight general tax issues that sellers should consider when exploring seller-financing options.
Seller Financing in a 1031 Exchange: Potential Tax Concerns
Let’s start by taking a look at how seller financing typically works and its impact on a 1031 exchange. First, the seller and the buyer negotiate the loan terms, including the payment schedule and the interest rate. Once the terms have been finalized, the buyer provides the seller with a promissory note. In a 1031 exchange transaction, this is where potential problems can arise.
IRS regulations regarding 1031 exchanges state that receiving “money or other property” in exchange for a relinquished property before the taxpayer actually receives the like-kind property will cause the transaction to be deemed a sale, rather than a deferred exchange. This is true even if the taxpayer ultimately receives the replacement property. It also applies whether the money or other property is received actually or constructively1.
When a seller receives a promissory note from a buyer, it falls under the IRS definition of “other property.” Unfortunately, this can cause the note to be deemed “boot,”2 making it immediately taxable. The receipt of the note also triggers recognition of 100% of depreciation recapture and causes the note to take on a tax basis of either its face amount or the tax basis of the relinquished property, whichever is lower.
These are potentially serious downsides that must be considered before combining seller financing with a 1031 exchange. However, there are some options that can help you mitigate or avoid this risk.
Navigating Seller Financing in a 1031 Exchange
Option 1: Cover the Note with Cash
If you have the financial means to do so, you could deposit a lump sum of cash equal to the total amount of the installment loan into your 1031 exchange escrow account. This shows the IRS that 100% of the proceeds from the sale of the relinquished property went directly into the escrow account to be used for the purchase of the replacement property.
As a result of handling the transaction in this way, the full 1031 exchange is tax-deferred, including depreciation recapture. The note’s tax basis is also equal to its face amount, rather than the carried-over basis from the relinquished property. While this may be the easiest solution, it requires you to have enough cash available to cover the full amount of the note upfront, excluding it as a viable option for many taxpayers.
Option 2: Make the Note Payable to Your QI
Rather than executing a note between yourself and the buyer, you could instead have the note made payable to your qualified intermediary (QI) at closing. In this scenario, the QI will receive both the note and any remaining cash proceeds from the sale, depositing both into your escrow account.
Before closing on the replacement property, you can instruct your QI to sell the note back to you or to a family member or close friend at full price and deposit the cash into your escrow account. This allows you to use the entire cash amount to purchase your replacement property and creates the same tax benefits as in the scenario above.
Option 3: Use the Note to Purchase the Replacement Property
In some rare circumstances, you may be able to convince the seller of the replacement property to accept the note as part of the sale transaction. To execute this, you would have the note issued in the name of your QI, then transfer it to the seller of the replacement property.
This would create the same tax benefits as above. In addition, it would also allow the seller of the replacement property to report the gain from the property sale on an installment basis. This creates an additional tax benefit, assuming the seller is not trying to engage in his or her own 1031 exchange.
This may seem like an appealing scenario. However, the major drawback here is that you’ll likely find it difficult to locate a seller who is willing to accept a third-party promissory note as part of the purchase price.
Importance of Meeting the 180-Day Rule in a 1031 Exchange
Regardless of the seller financing options selected by parties, in order to comply with 1031 exchange rules, the purchase of the replacement property must generally be fully completed by no later than 180-days after the close of escrow of the relinquished property. In many cases, this may not be feasible – e.g., if the buyer of the relinquished property is unable to obtain funds to complete the purchase. If so, an installment sale may be an alternative to consider.
Seller Financing via an Installment Sale
When seller financing within the time constraints of a 1031 exchange is not possible, the tax code provides for a tax deferral option via an installment sale.3
Let me explain this option by sharing a seller financing option that I personally used in one of my first real estate transactions.
When selling one of my first rental properties in the early 1980s, I was offered a higher than asking price by a buyer who was gainfully employed by Ford Motor Company. While he was making a good salary as an engineer, he was unable to qualify for a traditional bank loan due to being a recent emigrant and not having yet achieved sufficient credit status to qualify for a mortgage.
Interest rates were high at the time, and we decided that the buyer would pay me monthly interest payments on the purchase price at 12% per year and then pay the full principal as a balloon payment in the 5th year. As collateral, I held title to the property and it was agreed that, if any payments were missed, I could regain possession of the property and keep all payments received to that date.
Thankfully the buyer honored all his commitments and repaid all interest and principal as we had agreed.
My tax obligations under this installment sale were as follows:
- I was obligated to pay taxes on all interest income received over the 5-year installment sale period.
- I was able to defer paying any capital gains taxes on the sale until I had actually collected the principal which was owed and paid in year 5.
- I was not able to complete a 1031 exchange since the transaction was not fully concluded until well after 180-days following the close of escrow.
My capital gain was not great at the time, and it was more beneficial for me to collect the interest payments and ultimately receive a higher price for the property.4
The Bottom Line
Incorporating seller financing into a 1031 exchange is a complex and nuanced issue. As such, it’s a decision that should not be taken lightly and investors should consult knowledgeable real estate tax and legal advisors to determine if seller financing options may suitable before acting. If you are interested in exploring seller financing and working with a team of professionals who are well-versed in tax deferral strategies and can help you safely navigate the process. Contact us today to schedule a consultation with a member of our team.
1 Constructive receipt occurs when funds are credited into the taxpayer’s account or made available to them, even when they do not have actual possession of the property.
2 In a 1031 exchange, “boot” refers to additional value that is received and subject to taxes when a replacement property is acquired
3 https://www.irs.gov/taxtopics/tc705
4 If the note has been structured so that the buyer would pay both interest and principal (not just interest only following by a balloon payment), I would have been obligated to pay taxes on both the interest and the portion of principal received during the tax filing year.
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