Do Land Contracts For Deed Qualify for 1031 Exchange Treatment?
Land Contracts or Contracts for Deed are often misunderstood by investors in terms of how they should be treated for income tax reporting purposes, especially when the Land Contract or Contract for Deed is part of a 1031 Tax Deferred Exchange transaction.
Land Contracts or Contracts for Deed are difficult to explain because the terms can mean different things to different people in different geographic areas. The transaction strategies, structures and settlement processes can vary significantly from state to state, county to county or even town to town. However, the issue of a Land Contract or a Contract for Deed in conjunction with a 1031 Exchange does come up frequently enough that the topic is worth addressing.
Terminology: Land Contract or Contract for Deed
The fact that Land Contracts or Contracts for Deed can mean different things depending on the way they are drafted is what makes this topic so difficult to explain to investors. Generally, a Land Contract, Contract for Deed and/or a Contract for Sale mean the same thing, but not always, so you must pay close attention to the way the legal document has been drafted. And, make sure that the terminology that you are working with is appropriate to the geographic area where the real property is located.
1031 Exchanging Property Sold Under a Land Contract
Here is an example of a sale of real property under a Land Contract with a 1031 Exchange. A real estate investor sold investment property a number of years back under a Land Contract. The buyer is now in a position to pay off the entire balance due under the Land Contract. The real estate investor is obviously going to receive a significant lump sum payment under the Contract for Deed and is concerned about his or her capital gain taxes that will be due to the IRS upon receipt of the lump sum payment. The real estate investor wants to know if he or she can structure a 1031 Tax Teferred Exchange using the proceeds received from the payoff.
1031 Tax Deferred Exchange
Real estate investors can structure a 1031 Tax Deferred Exchange and defer the payment of their depreciation recapture taxes and capital gain taxes provided they acquire like-kind replacement property as part of the 1031 Exchange. The real estate investor must relinquish an interest in real property and subsequently acquire an interest in real property during certain 1031 Exchange deadlines in order to qualify for tax-deferred exchange treatment.
Right to Own, Use, Possess the Real Property
The key issue in this case is when exactly did the buyer have ownership rights to the subject real property? We need to determine when the rights of ownership actually transfer to the buyer. Do the rights to own, use, and possess the property transfer upfront upon execution of the Land Contract or at the back end when the Land Contract is actually paid off by the buyer?
Generally, a Land Contract or Contract for Deed results in the immediate sale and transfer of rights to the real property to the buyer upfront and provides for financing or payments over a period of time. The legal title to the property is retained by the seller as a security device rather than a recorded lien against the title, but the buyer does have all of the benefits and burdens of ownership and has the right to own, use, and possess the property as he or she sees fit.
However, there are some contracts that do not transfer all of the rights to the real property until the backend of the transaction when the debt is paid in full by the buyer. This is why you must be careful to read the contract and understand what rights are transferred and when the rights are transferred to the buyer. You should consult with your legal and tax advisors to make sure that you know exactly what affect your contract will have.
Installment Sale Treatment Under Section 453
So, assuming that the Land Contract or Contract for Deed does in fact transfer all of the rights and benefits of ownership to the buyer upfront at the time of execution of the Land Contract, like most of them do, the transfer or conveyance of the real property is considered to have occurred upfront for tax purposes.
The Land Contract or Contract for Deed in this case is treated just like an installment sale contract or installment sale note, also referred to as a seller carry back note. It can be drafted outside of the 1031 Tax Deferred Exchange and would be taxable as an installment sale note under Section 453 of the Internal Revenue Code. It can also be drafted as part of the 1031 Exchange so that the investor can still defer all of his or tax liabilities.
Generally, for this reason, most real estate investors will want the Land Contract to be drafted so that it is included inside of the 1031 Tax Deferred Exchange account so that the investor can defer all of his or her depreciation recapture taxes and capital gain taxes.
However, this means that the Land Contract will complicate the investor's ability to structure and complete a 1031 exchange transaction because the transfer or closing has occurred upfront upon the execution of the Land Contract. And, the Land Contract has been drafted to be included in the 1031 Tax Deferred Exchange, but the investor is not holding all cash in his or her 1031 Exchange account in order to complete his or her 1031 Tax Deferred Exchange by acquiring like-kind replacement property. The Land Contract must somehow be converted into cash in order to complete the investor's 1031 Exchange.
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