Seller Financing Strategies & Carry Back Options in 1031 Exchanges

For sellers, providing financing can expand their pool of potential buyers, particularly those who may struggle to secure traditional financing due to stringent lending criteria. This increased buyer interest can lead to a quicker sale and potentially a higher sale price. Additionally, offering seller financing can generate a steady stream of income from interest payments, which can be particularly appealing in a low-interest-rate environment where other investment opportunities might yield lower returns.

For buyers, seller financing can make acquiring a property more accessible, especially when conventional loans are challenging to obtain. This flexibility is crucial in a competitive real estate market where acting quickly can secure desirable properties. Moreover, seller financing can offer more favorable terms, such as negotiable interest rates or more flexible repayment schedules, compared to traditional bank loans. These advantages can significantly ease the financial burden on the buyer, making it an attractive option for those looking to complete a 1031 Exchange and defer capital gains taxes while acquiring a new investment property.

How to Incorporate Seller Financing in a 1031 Exchange

In most cases, it is preferable for the seller (Exchanger) to receive all cash for the sale of the Relinquished Property. However, many real estate sale transactions require the seller to “carry back” a part of the purchase price as financing to assist the buyer in purchasing the property or seller financing is used to strategically enhance a 1031 Exchange transaction.

Here are a few ways to use seller financing strategies in your 1031 Exchange:

Carry Back Options

Depending on the sales price, adjusted basis, down payment and amount of note from the Buyer, the Exchanger may elect to do one of the following:

Carry the Note Back with No Exchange (Taxable):

Treat the transaction as a pure sale and recognize gain from cash received above basis, if any, in the year of the sale and treat buyer’s promissory note as an installment sale (IRC §453) and pay any capital gain taxes on the principal payments on the note when these payments are received by the Exchanger; or

Carry the Note Back with Exchange (Taxable):

​Combine the seller-financing portion of the sale with a tax-deferred exchange for the balance of the Relinquished Property (Treas. Reg. §1.1031(k)-1(j)(2)).  The capital gain attributable to the portion of the Relinquished Property that was exchanged will be deferred into the Replacement Property and the capital gain that is attributable to the installment note will be deferred over the life of the note and recognized upon receipt of the principal. Section 453(f)(6) provides that the basis is first allocated to the Replacement Property and only the amount of the basis in excess of the fair market value of the Replacement Property will be allocated to the installment note. Accordingly, most of the basis on the sale property will be allocated to the Replacement Property and the installment note will have little or no basis, which means, most of the payments received will be fully taxable.

Example of Carry the Note Back with an Exchange

To illustrate, let’s assume that Ted Taxpayer sells a property for $1,000,000 (with a basis of $800,000) and he wants to acquire like-kind real estate worth $700,000 and receive the balance of the price, $300,000, in the form of an installment note. The basis from the property is first allocated to the Replacement Property, then to the installment note. As a result, the Replacement Property has a basis of $700,000 and the note has a basis of $100,000 (which will result in two-thirds of the payments of the note will be taxable.

Fund Cash as a Lender (Can be Fully Tax Deferred):

Provide the funds required for the seller-financing from the Exchanger’s own funds at the closing of the relinquished property, thereby acting as a “third-party lender” for the buyer; or

Have Qualified Intermediary Take the Note into the Exchange (Can be Fully Tax Deferred):

Include the seller-financing note as part of the exchange by naming the Qualified Intermediary as the payee of the note and beneficiary of any trust deed or mortgage at the close of the relinquished property. The value of the note must be converted to “down-payment equity” to be used by the Qualified Intermediary for the purchase of the Replacement Property (Treas. Reg. §1.1031 (k)-l(j)(2)).

Next Steps for QI – The Qualified Intermediary Will:

1. Assign the Note to the Replacement Property Seller (Fully Tax Deferred):

Although this results in a complete deferral of gain into the Replacement Property for the Exchanger, the seller of the Replacement Property does not get installment sale treatment on the receipt of the note; or

2. Sell the Note to a Third Party (Can be Fully Tax Deferred):

Then use the cash to purchase the Replacement Property. The Exchanger must consider whether a discount charged by the buyer of the note, if any, exceeds or is offset by the capital gain tax that would have been paid under the normal installment sale rules. Note: Sometimes the Lender for the Replacement Property will be willing to purchase the note at no discount since they receive the Relinquished Property as collateral; or

3. Sell the Note to the Exchanger or “Friendly” Party (Can be Fully Tax Deferred):

Then use the cash to purchase the Replacement Property; resulting in deferral of gain into the Replacement Property. While there is no legal authority as to whether the Exchanger can successfully use this option to defer the note proceeds into the Replacement Property, the approach is reasonable and if done properly should result in favorable treatment. However, the Exchanger should only use this method upon the advice of their tax or legal counsel.  Also, the Exchanger or the friendly party should not purchase the note at a discount; or

4. Assign the Note to the Exchanger (Taxable):

If the note cannot be converted to down-payment equity, then the note will be reassigned to the Exchanger at the termination of the exchange. The Exchanger will receive the same installment sale treatment under IRC §453 as if the Exchanger had not attempted to defer the note through the exchange. Moreover, the date for commencement for the installment sale treatment is the date the note is reassigned to the Exchanger from the Qualified Intermediary and not the date of sale of the Relinquished Property.

Taxpayers should always consult with their tax advisor for advice with respect to their individual situation.

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Seller Financing Combined with a Tax Deferred Exchange
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