Imagine a difficult real estate deal in a tough market. The sellers think they have gold, and the buyers think it is still 2008. After protracted negotiations, the parties finally agree to terms and want to get to the closing table before anyone changes their mind. But the buyer needs financing, and the banks are saying they need 30 days minimum. The parties don’t want to wait, so they agree that the buyer will give a mortgage to the seller as part of the purchase price. This allows the deal to close quickly and gives the buyer time after closing to get conventional financing. Problem solved, right?

Not so fast. The seller plans to do a §1031 exchange. Does seller financing create a problem?

The issue

To fully defer capital gain taxes in a §1031 exchange, the taxpayer must acquire replacement property that costs at least as much as the relinquished property being sold, and spend all of the equity from the sale. In a typical transaction, the equity is available as cash. When seller financing is involved, the equity takes the form of a promissory note, which means cash is not available to spend on replacement property.

Solutions

One solution is to do nothing. Under IRC §453, most seller financing is taxed under the “installment method.” Only the payments the taxpayer receives each year are subject to taxation, allowing the taxpayer to spread the tax over the term of the loan.

Alternatively, the taxpayer can elect to do a §1031 exchange, provided they can somehow use the debt toward the purchase of replacement property. Many tax advisors suggest this can be done by including the note in the exchange (making the qualified intermediary, rather than the taxpayer, the payee) and doing one of the following:

  • Buy the note. The taxpayer can buy the note from the qualified intermediary for cash, making the funds available for the purchase of the replacement property. This is useful when the taxpayer plans to spend their own non-exchange funds on the replacement property anyway.
  • Make the note short-term. The term of the note could be set for less than 180 days (the maximum time to complete the exchange), or by the date the taxpayer needs to close on the replacement property. The debtor would make payments to the qualified intermediary, who would then have funds available to acquire the replacement property.
  • Buy property with the note. The taxpayer can offer the note to the seller of the replacement property as part of the consideration. The seller might be willing to accept the note in lieu of the cash otherwise necessary to close.
  • Sell the note. The qualified intermediary can sell the note to a third party. Promissory notes are often sold to investors attracted to generally above-market interest rates. However, because notes are usually sold at a discount, this option may reduce the benefit of doing a §1031 exchange.

Seller financing can speed up the closing of a real estate transaction, or even rescue a deal where a buyer can’t obtain conventional financing. However, like any other §1031 exchange, proper planning is key.