Seller Financing and 1031 Exchanges: How to Handle a Note

Offering to carry back a note can help you sell a property faster or at a better price. But if you also want a 1031 exchange, seller financing creates a problem: a promissory note is not like-kind real estate. Unless it is handled correctly at closing, the note becomes taxable boot. Here is how seller financing interacts with an exchange, and the ways to keep the note from costing you tax.

Why a note causes trouble

To defer all of your gain, you must reinvest all of your net sale proceeds in like-kind real estate. When your buyer pays part of the price with a note, that part of the price never reaches your exchange as cash. If the note is made payable to you, it is treated as property you received outside the exchange, which means:

• Gain up to the amount of the note is taxable.
• You may be able to report that gain under the installment method as the buyer makes payments, but any depreciation recapture taxed as ordinary income (for example, on components broken out in a cost segregation study) is taxed in the year of the sale, even if you haven't been paid yet.

For example, you sell a rental for $1,000,000: $700,000 in cash at closing and a $300,000 note from the buyer. If the $700,000 goes to your exchange and the note goes to you, up to $300,000 of gain is taxable, even if you buy replacement property worth $1,000,000.

Step one: make the note payable to your intermediary

If you want the note to be part of your exchange, it must be made payable to your qualified intermediary, not to you, at the closing of your sale. Payments made on the note during the exchange go to the intermediary too. This has to be in the closing documents; it can't be fixed afterward.

Once the intermediary holds the note, it has to be turned into value for your replacement purchase before the exchange ends. There are four common ways to do that.

Four ways to keep the note in the exchange

1. The buyer pays off the note early

If the note is short-term, or your buyer can refinance within the 180-day exchange period, the buyer pays the note in full to the intermediary. The payoff joins the rest of your exchange funds. This is the cleanest outcome, but it depends on the buyer.

2. You buy the note from the intermediary

Before or at the closing of your replacement property, you pay the intermediary cash equal to the note's balance, and the intermediary assigns the note to you. The intermediary uses your cash, together with the other exchange funds, to buy the replacement property. You keep the note and collect payments outside the exchange. This is the most commonly used method, but it requires you to have cash available, and your CPA should review how it will be reported.

3. The intermediary sells the note to an investor

Notes can be sold to investors who buy real estate paper, and the cash from the sale goes into the exchange. Expect the note to sell at a discount, especially if it has a low interest rate, a long term or a borrower with limited credit history.

4. The seller of your replacement property accepts the note

In rare cases, the seller of your replacement property agrees to take the note as part of the purchase price. The intermediary assigns the note to that seller at closing. Few sellers will accept a note they didn't underwrite, but it can work in some deals.

If none of these happens by the end of the exchange period, the intermediary returns the note to you after the exchange ends, and the note is treated as boot.

Seller financing on the purchase side

The issue is different when the seller of your replacement property offers financing. A note you sign to buy replacement property is debt, like a bank mortgage. It counts toward replacing the debt paid off on your old property, so it can help you meet the rule that you must take on equal or greater debt (or add cash) to defer all of your gain.

Decide before you sign the sale contract

• Choose your approach before you agree to carry back a note, because it affects the note's terms.
• Make sure your title or escrow officer knows the note must name your qualified intermediary as the payee.
• Keep the note's payments flowing to the intermediary until the note is resolved.
• Ask your CPA how the chosen method will be reported, especially if you plan to buy the note yourself.

Seller financing and a 1031 exchange can work together, but only if they're planned together. If you are considering carrying back a note, talk to us before you accept an offer. For more on taxable cash and debt, see our guide to avoiding boot.