1031 Exchanges with Seller Carry-Back Notes
During times of rising interest rates or tight credit markets, good real estate deals often can fall through as buyers struggle to secure financing. Sellers that are willing to “act as the bank” can be in a powerful position when negotiating and structuring transactions.
Through a process that’s known as a “seller carry-back installment” or a “seller carry-back note,” sellers can help get a deal closed and receive potential tax advantages as well.
Such a financing agreement does require some preparation and advanced tax planning. This is especially true if you want to complete a 1031 exchange combined with a seller carry-back note.
Excluding the seller carry-back note from the 1031 exchange
If a seller’s carry-back note is excluded from a 1031 exchange (i.e., only the buyer’s cash payment is being replaced), then only the cash proceeds from the sale are sent to the Qualified Intermediary (“QI”) at the close of a relinquished property transaction. For 1031 purposes, the amount of the note is not yet considered to be sold.
As the seller, you would be left with an installment note where capital gain income taxes would be deferred and taxed as you receive each future principal payment. However, depreciation recapture income taxes are NOT deferred and would be taxed in the year in which the relinquished property sale transaction initially closes.
Including the seller carry-back note in the 1031 exchange
Conversely, by including the seller carry-back note in the 1031 exchange transaction, the QI would function as the beneficiary/owner instead of you. This allows you to defer capital gain and depreciation recapture income taxes indefinitely through the 1031 exchange.
In this option, the QI would receive the carry-back installment note as well as the net proceeds from the sale. Any note payments are then paid to the QI during this time.
Things to be aware of when including an installment note in a 1031 exchange
While seller carry-back financing and 1031 exchanges are often combined in the same transaction, it does introduce additional complications because your QI is holding more than just cash in your 1031 exchange account.
There are three potential ways a QI can utilize your seller carry-back note when acquiring your like-kind replacement property:
- The installment note is part of the consideration paid for the purchase of your like-kind replacement property. This assumes that a seller would be willing to accept the third-party installment note as full or partial consideration their property…possible, but not very practical.
- The installment note can be converted into cash by selling it to a third-party investor. This could be a viable option, but in most cases the installment note would have to be sold at a significant discount.
- You could contribute additional personal funds into your own 1031 exchange account equal to the face value of the installment note, so that sufficient cash funds now exist inside your 1031 exchange in order to complete the acquisition of your like-kind replacement property.
In this last scenario, the note and deed of trust or mortgage would then be endorsed/assigned to you after your 1031 exchange transaction has been completed. If you have the necessary liquidity to fund this strategy, it is probably the most practical. This option results in the boot received being offset by the boot paid and therefore does not generate any income tax consequences.
Each seller carry-back option has its pros and cons from a tax perspective, and each includes various levels of complication. Note that once the relinquished property sale transaction has closed, you cannot change your mind, so it’s important to consult with your advisors ahead of time to determine which option is best for your situation.
For more information about tax-advantaged securitized real estate investments, please call 1031 Capital Solutions at 1-800-445-5908 or visit our website, 1031capitalsolutions.com.
This is for informational purposes only, does not constitute as investment advice, and is not legal or tax advice. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. Please consult the appropriate professional regarding your individual circumstance.
This material is not to be interpreted as tax or legal advice. IRC Section 1031, IRC Section 1033 and IRC Section 721 are complex tax concepts, therefore you should consult your legal or tax professional regarding the specifics of your particular situation.
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 Seller Carryback Financing: When the Seller Becomes the Bank. The Truth about Mortgage.com
 Seller Financing Strategies and 1031 exchanges, First American Exchange
 Depreciation Recapture, Investopedia.com, March 31, 2022