1031 and Seller Carry

Seller carry back financing is a real estate transaction where the seller finances a portion of the property purchase price. So how does a seller carry back work? In these instances, the seller essentially acts as a lender, giving the buyer a loan instead of receiving the full purchase price upfront. This can be referred to as ‘seller carry back note’, ‘seller carry back financing’, or ‘seller financing’. Some may also choose to combine seller carry back financing with 1031 Exchanges. A 1031 Exchange allows you to defer paying capital gains tax on the sale of a business or investment property by reinvesting the proceeds in other real estate. There are certain scenarios in which you can combine seller carry back financing and a 1031 Exchange. We’ll explain those specific scenarios in this article. Treas. Reg. §1.1031(k)-(1)(j)(2) provides guidance for coordinating the tax deferral benefits of IRC §1031 with the installment sale benefits of IRC §453.

3 Seller Financing Scenarios & Options

There are three main scenarios where the seller carry back financing and 1031 Exchanges can be combined. For each scenario below, assume that the exchanger sells the Relinquished Property for $100. The buyer wishes to pay $20 cash and give a promissory note for the balance of $80.

1. Exchanger has access to additional cash and desires an income stream.

Exchanger funds $80 cash at closing of the Relinquished Property sale, representing Exchanger’s loan to the buyer. (Exchanger may borrow the cash necessary to loan to Buyer.) Qualified Intermediary receives $100 cash from sale of Relinquished Property. Exchanger receives the buyer’s note (payable to Exchanger) and security instrument outside of the exchange.

Exchanger’s basis in the note is $80; principal payments on the note are nontaxable as return of principal, interest payments are taxable as ordinary income, as received. Qualified Intermediary uses $100 to buy Replacement Property, allowing for a completely Tax-Deferred Exchange.

2. Exchanger does not have cash to fund the loan to the Buyer outside of the exchange.

Upon closing the sale of the Relinquished Property, Qualified intermediary receives the $20 cash and a promissory note (and security instrument, if any) from the buyer for $80, payable to the Qualified Intermediary. When the Exchanger is ready to acquire Replacement Property, Exchanger can arrange for Qualified Intermediary to sell the note

(1) to Exchanger for the remaining principal balance due on the note (Exchanger may borrow the cash necessary to purchase the note), OR

(2) to a third party note buyer (but any discount will be treated as boot and will reduce the amount of gain deferred), OR

(3) to the lender that will make the loan to the Exchanger for purchase of the Replacement Property Qualified Intermediary then has $100 cash with which to buy Replacement Property allowing the Exchanger to defer all of the gain. If the Exchanger has purchased the note, Exchanger will have an $80 basis in the note. Principal payments on the note will be non-taxable as return of principal; interest payments will be taxable as ordinary income, as received.

Alternatively, Exchanger can arrange for the Qualified Intermediary to assign the note to the Replacement Property seller as part of the purchase price, along with the $20 cash, resulting in complete deferral of gain.

3. Exchanger does not have cash to fund the loan to the Buyer outside of the exchange and the exchange partially or completely fails.

The Qualified Intermediary is holding $20 of Exchange Funds and the buyer’s note, but the Exchanger is unable to fully complete the exchange and carries back (i.e. retains) the $80 promissory note as a result. Qualified Intermediary uses $20 cash to acquire Replacement Property, but the Exchanger is unable to identify and acquire any additional Replacement Properties. Upon termination of the exchange, the Qualified Intermediary assigns the note and security instrument to the Exchanger.

Basis in the Relinquished Property will be allocated first to the Replacement Property, with any basis in excess of $20 allocated to the note. To the extent that Exchanger’s basis in the Relinquished Property was less than $20, gain that was rolled into the Replacement Property will be deferred indefinitely. Recognition of the gain attributable to the note will be spread over the life of the note. Pursuant to the installment rules under IRC §453, the Exchanger will recognize and pay capital gains tax on the gain allocated to the note incrementally, and ordinary income tax on the interest, as the payments are received.

Seller Financing & 1031 Exchange Considerations

There are several considerations when combining seller carry back financing and 1031 Exchanges.

With seller carry back financing, the seller acts as a lender providing a loan to the buyer. The seller takes on the risks in this situation. For instance, if the buyer defaults on the loan it could lead to foreclosure and the seller regaining possession of the property. Other potential risks include if the seller’s funds are tied up in the property, it may limit their ability to invest elsewhere. If the buyer defaults, the seller may face challenges in selling the property again, especially if market conditions have deteriorated.

Seller carry back financing can be a complex process. It’s important to accurately value the property in order to determine the loan amount and interest rate. It’s also crucial to create comprehensive loan documents that protect both parties. Both the buyer and seller should consult with tax professionals to understand the potential tax consequences.

If you want to do a 1031 Exchange and provide financing to the buyer, you need to decide how to handle the seller carry back note. It can be kept out of the exchange altogether, or can be included based on certain stipulations.

Excluding the Seller Carry Back Note from a 1031 Exchange

Excluding a seller carry back note from a 1031 Exchange will limit the tax deferral. The portion represented by the note becomes taxable gain, considered “boot” since it’s not a like-kind property. Additionally, if you receive payments on the seller carry back note over time, you may be subject to installment sale rules. This would require you to report a portion of the gain as income year after year as you receive payments on the note.

Conclusion

Seller carry back financing can be a valuable tool in real estate transactions. However, it’s important to consider the potential risks and benefits of this strategy. By understanding the different scenarios and tax implications, you can make informed decisions and maximize the potential tax benefits of a 1031 Exchange and a seller carry back note. Contact a 1031 expert today for more information.