Given the current tight credit market, taxpayers who want to initiate a 1031 exchange may consider financing or carrying a note for a Buyer to acquire the relinquished property. A 1031 exchange is a strategy to defer the federal and state capital gains and recaptured depreciation tax when selling and replacing property held for productive use in a trade, business or for investment. The tax deferral represents an indefinite, interest free loan that can defer upwards of 40 percent of the sales price. 1031 eligible property includes real property such as timberland, self-storage units, commercial property, single family residential, oil and gas royalty interests as well as personal property including aircraft, precious metals, vintage cars, artwork and collectibles.
Structuring Seller Financing
The Buyer in a typical 1031 exchange acquires the relinquished or old property from the Exchangor with cash, debt or combination of the two. If the Buyer is not able to secure financing, the Exchangor may consider carrying the note. In effect, the note represents an installment loan; however, in a 1031 exchange, the Buyer’s note does not offset debt on the replacement property. The note must be converted into cash by one of the following methods:
- Assigning the note to the seller of the replacement property as partial payment
- Selling the note to a third party
- The Exchangor or related party adding the cash equivalent of the note to the exchange as additional equity
The first two options may not be feasible, leaving the third option dependent upon whether the Exchangor has access to the note’s cash equivalent.
1031 Exchange Carry Back Note Steps
Given the Exchangor has the capital, the carry back note is negotiated between the Exchangor and the Buyer as normal. Prior to the relinquished property closing, the note is made payable by the buyer to the Qualified Intermediary. The relinquished property title is conveyed to the Buyer with a deed of trust and prior to the closing on the replacement property, the Qualified Intermediary sells the note to the Exchangor or a related party. Debt service payments, if any, are paid to the Qualified Intermediary and deposited into an escrow account along with the proceeds of the note sale used to acquire the replacement property. There is no tax when the Exchangor or related party receives principal payments on the note given they will have paid face value to acquire the note. Consequently, all payments other than interest are non-taxable.
One of the benefits of the carry back method described above is, should the replacement property not be acquired, the exchange fails and tax is reported on the installment method in the year the principal and interest payments are received.
Should the note be paid off to the Qualified Intermediary prior to the purchase of the replacement property, the proceeds are used towards the acquisition.
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