1031 Exchange Library

Seller Carry-back Notes and 1031 Exchanges

Closing investment real estate transactions can be particularly challenging during a rising interest rate environment, an economic downturn, a tight credit market, or other distressed real estate market conditions. Lenders frequently impose stricter borrowing requirements during these times. Consequently, buyers (borrowers) may no longer qualify for financing and therefore not be able to purchase investment real property.

In these situations, sellers may want to consider offering seller financing (installment note) to the buyer (or the buyer may request the seller to consider seller financing) to help the buyer finance the purchase of the investment real estate. Seller financing is commonly referred to as a “seller carry-back note,” “seller carry-back financing,” or just “seller financing.” Seller financing can be in the form of a promissory note secured by either a deed of trust or a mortgage, or it can be in the form of a contract for deed or land contract.

Seller financing can be a highly effective tool when negotiating and structuring the sale and purchase of investment real estate during difficult times. Seller financing can also serve as a valuable income tax planning and/or estate planning strategy as an alternative to the 1031 Exchange when sellers do not want to reinvest in investment real property.

Complications With Seller Financing and 1031 Exchanges

The widespread belief is that seller financing and 1031 Exchanges cannot be used together. This is simply not true. Sellers can structure a 1031 Exchange with a seller carry-back note. However, using them together is considerably more complex and requires careful planning to ensure a smooth and successful 1031 Exchange transaction. Seller financing is extremely beneficial to the buyer while the seller assumes all of the risks. Sellers should therefore always discuss these transactions with their own legal, tax and financial advisors in conjunction with Exeter 1031 Exchange Services, LLC before entering into any Purchase and Sale Agreement.

The combination of a seller carry-back note and a 1031 Exchange is more difficult because all the “net proceeds” from the sale of real property held for rental, investment, or business use (Relinquished Property) must be used (reinvested) toward the purchase of real property also held for rental, investment, or business use (replacement property). The “net proceeds” includes the cash and the seller carry-back note. This means the seller carry-back note must be used toward the purchase of replacement property if the seller is to defer all his or her taxable gain.

Seller Carry-back Notes – Inside or Outside the 1031 Exchange

Seller carry-back notes can be included in (tax deferred) or excluded from (taxable) the seller’s 1031 Exchange transaction. Including the seller carry-back note in the 1031 Exchange will defer all the seller’s taxable gain as part of the 1031 Exchange transaction because all the net proceeds are being reinvested in replacement property. Excluding the seller carry-back note from the 1031 Exchange will recognize some or all the seller’s taxable gain because part of the net proceeds (e.g., the seller carry-back note) is not being reinvested in replacement property. The five (5) options for structuring a seller carry-back note with a 1031 Exchange are discussed below.

Including or excluding seller financing in a 1031 Exchange transaction is an extremely complicated matter with significant income tax implications. Promissory notes (installment notes) secured by either a deed of trust or mortgage, or contracts for deed or land contracts, are drafted differently depending on the seller’s decision. It is therefore crucial that sellers carefully discuss their options with their own legal, tax, and financial advisors beforehand to ensure they make the best possible choice for their specific situation. Sellers are not able to change their decision once the sale of the Relinquished Property has closed.

Including the Note in the 1031 Exchange – 1031 Exchange Treatment

Sellers generally wish to defer all their taxable gains from the sale of the Relinquished Property and therefore usually choose to include the seller carry-back note in the 1031 Exchange transaction. The promissory note (installment note) secured by either a deed of trust or mortgage, or contract for deed or land contract, will be drafted differently depending on how the seller carry-back note is included in the 1031 Exchange.

The Purchase and Sale Agreement for the sale of the Relinquished Property is assigned to the Qualified Intermediary. The Qualified Intermediary becomes the seller. The entire net proceeds from the sale of the Relinquished Property consisting of the equity (net cash proceeds) and the seller carry-back note (if applicable) will be included in the 1031 Exchange.

The seller carry-back note is tax-deferred when included in the 1031 Exchange. The seller’s taxable gain is indefinitely deferred as long as the seller continues to exchange throughout his or her lifetime (often referred to as “swap until you drop”).

Five (5) Options or Strategies

Sellers generally have five (5) options or strategies to choose from when structuring a seller carry-back note and a 1031 Exchange on the sale of their Relinquished Property. These five (5) options include:

  • Seller Funds the Note at Closing.

    The seller acts as the lender and contributes new out-of-pocket cash into the closing of the sale of the Relinquished Property to "fund" the seller carry-back note. The seller is literally lending money to the buyer (borrower) and the promissory note is drafted in the name of the seller as the beneficiary or lender. The Qualified Intermediary therefore receives all cash at closing and can complete the 1031 Exchange by acquiring the identified replacement property(ies). This is the cleanest and most efficient of the five (5) options or strategies provided the seller has adequate out-of-pocket cash to fund the note.

  • Seller Funds the Note After Closing.

    The seller can raise the cash needed to fund the seller carry-back note, but not in time for closing. The seller needs time to raise the cash. The seller carry-back note is drafted in the name of the Qualified Intermediary (or in the name of the Trustee of the Qualified Trust Account). The sale closes and the Qualified Intermediary (or the Trustee of the Qualified Trust Account) receives and holds the net proceeds (cash and the seller carry-back note) in the 1031 Exchange. The seller (preferably an affiliate of the seller) raises the needed cash and deposits the cash into the 1031 Exchange account (boot paid) before closing on the purchase of the replacement property. The seller carry-back note is endorsed (assigned or transferred) to the seller after his or her 1031 Exchange has been completed (boot received). The boot paid and boot received net to zero so there is no tax consequence. This is often described as buying the seller carry-back note out of the 1031 Exchange account. The Qualified Intermediary is now holding all cash and can complete the 1031 Exchange by acquiring the identified replacement property(ies). Sellers are often unable to raise the needed cash and therefore unable to implement the first two (2) options or strategies discussed above. The following three (3) options or strategies might be viable alternative solutions in these cases.

  • Seller Sells the Note After Closing.

    The seller carry-back note is drafted in the name of the Qualified Intermediary (or in the name of the Trustee of the Qualified Trust Account). The sale closes and the Qualified Intermediary (or the Trustee of the Qualified Trust Account) receives and holds the net proceeds (cash and the seller carry-back note) in the 1031 Exchange. The Seller arranges for the Qualified Intermediary (or the Trustee of the Qualified Trust Account) to sell the seller carry-back note to a buyer to convert the note to cash. The Qualified Intermediary is now holding all cash and can complete the 1031 Exchange by acquiring the identified replacement property(ies). This can be an expensive option as note buyers generally expect a significant discount to buy the seller carry-back note.

  • Seller Uses the Note as Payment for Replacement Property.

    The seller carry-back note is drafted in the name of the Qualified Intermediary (or in the name of the Trustee of the Qualified Trust Account). The sale closes and the Qualified Intermediary (or the Trustee of the Qualified Trust Account) receives and holds the net proceeds (cash and the seller carry-back note) in the 1031 Exchange. The seller locates and identifies replacement property. The seller carry-back note is endorsed (assigned or transferred) to the seller of the replacement property as part of the payment or consideration for the purchase of the replacement property. The seller of the replacement property must be willing to accept an endorsement of the note as part of the consideration for the purchase of the replacement property.

Excluding the Note From the 1031 Exchange ‐ Installment Sale Treatment

  • Seller Excludes the Note from the 1031 Exchange.

    The last option available to the seller is to exclude the seller carry-back note from his or her 1031 Exchange. Only the equity portion (net cash proceeds) generated from the sale of the relinquished property is included in the 1031 Exchange. The seller carry-back note is drafted in the name of the seller as beneficiary or lender (outside of the 1031 Exchange).

    The seller carry-back note represents net proceeds generated from the sale of the relinquished property that are not reinvested and are therefore “taxable boot.” Seller carry-back notes (i.e., promissory notes or installment notes) that are excluded from the 1031 Exchange are taxable under the installment sale rules pursuant to Section 453 of the Internal Revenue Code (IRC).

    Generally, the taxable gain realized by excluding the seller carry-back note from the 1031 Exchange is deferred over the term of the installment note and recognized (taxable) on a prorata basis based on the percentage of principal payments made on the installment note each year. The remainder of any deferred gain will be immediately recognized (taxable) when the entire outstanding principal balance of the installment note is paid off.

Depreciation Recapture Income Tax Issues

Generally, including the seller carry-back note inside the 1031 Exchange transaction will defer the recognition of most depreciation recapture. Excluding the seller carry-back note from the 1031 Exchange may result in the immediate recognition of certain depreciation recapture. Sellers should always consult with their own tax advisors regarding the income tax consequences of a seller carry-back note.

Special Consideration for Installment Notes in Excess of $5 Million

There are special considerations sellers should review with their tax advisor when the initial principal amount of the seller carry-back note exceeds $5 million. Sellers can only defer the recognition of the taxable gain on the first $5.0 million. The remaining taxable gain related to the balance of the installment note that exceeds $5.0 million will be recognized in the year in which the sale of the Relinquished Property transaction closed. Although this portion of the taxable gain will be recognized immediately, the Internal Revenue Services (IRS) will allow the seller to defer the actual payment of the taxes over the term of the installment note but will assess interest on the unpaid deferred tax liability.

Other Considerations Related to Seller Carry-back Notes

Note payments made during the time the seller carry-back note is held by the Qualified Intermediary (or the Trustee of the Qualified Trust Account) must be made to the Qualified Intermediary or Trustee. Interest income paid on the seller carry-back note is taxable as ordinary income to the seller in the year in which the interest income is paid to the holder of the note (beneficiary or lender).

The servicing agent or collection agent is generally responsible for filing IRS Form 1099INT (interest income) that reports to the IRS the amount of interest income received by the seller and for filing IRS Form 1098 (mortgage interest) that reports to the IRS the amount of interest paid by the borrower.

Including the Note as Part of a Reverse 1031 Exchange

Obtaining financing when structuring a Reverse 1031 Exchange is challenging during any market conditions. Seller carry-back notes can also be very effective tools in structuring Reverse 1031 Exchange transactions. The seller carry-back note is treated like any other type of debt when structured as part of the purchase of replacement property in a Reverse 1031 Exchange.

 

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