Seller financing is becoming more popular. As interest rates remain high and purchasers find it increasingly difficult (or less desirable) to get third-party financing, motivated sellers can finance a portion of the purchase price on their behalf. The buyer pays the agreed-upon down payment and signs a promissory note to the seller (referred to as a "seller carryback note," or "note") for the remainder at the closing. If the transaction is structured as an installment sale under IRC Section 453, the seller pays tax on any gain from the sale over time when the payments on the note are received, rather than paying tax on the entire gain in the year of sale.

If an investor is considering a tax-deferred exchange under IRC 1031 and intends to finance their buyer, they must decide how to handle the seller carryback note. The note can be kept separate from the exchange or, under the criteria outlined below, an exchanging taxpayer can incorporate the note in their exchange and postpone all gains from their sale.

IF THE NOTE IS NOT PART OF THE EXCHANGE

The note is not included in the 1031 exchange in many trades involving seller carryback financing. In such circumstances, the note is taxable boot, but the tax is paid over time as payments are received on the note. The taxpayer may get enough cash from the sale to justify moving those monies to a qualified intermediary (or "QI") in order to delay a portion of the gain while still paying some taxes
When the note is not included in the exchange, it is made payable to the seller and given to the seller immediately at the time of closing. Only the sale revenues in cash are given to the seller's QI.

THE EXCHANGE INCLUDES A NOTE

If an investor want to delay all gains in their 1031 exchange, they have several options. In each scenario, the note is rendered due to the QI directly at the closing of the relinquished property, preventing the investor from constructively acquiring the note for income tax purposes, which would immediately make the note taxable boot. The QI is responsible for collecting any note payments made during the exchange, which are a part of the exchange earnings.

To be utilized for the purchase of replacement property, the note must either be converted to cash prior to the closing of the replacement property, or the seller of the replacement property must agree to accept the note as whole or partial payment for the property (this is rather uncommon).

Conversion of a Note to Cash

During an investor's exchange, a note can be converted to cash in three ways. The first scenario occurs when the note is a short-term note that matures before the investor needs close on their replacement property. During the exchange period, the borrower pays any note payments and the final payoff total directly to the QI. The funds are then used to acquire a replacement property. However, timeliness is critical: all relevant funds must be collected prior to the replacement property's closing date.

Another option is for the investor to arrange for a separate third party to buy the note. As beneficiary, the QI assigns the note to the third-party note buyer, and the note purchase payments are transferred to the QI as exchange proceeds. The money are subsequently used by the QI to purchase the new property.

An exchange investor might potentially purchase the note directly from the QI. The note is assigned to the investor, and the note purchase monies are used as exchange proceeds to purchase the replacement property. The note's purchase monies can be forwarded straight to the QI or placed directly into the replacement property escrow by the Exchangor.

Purchase Replacement Property with the Note

An investor may be able to negotiate assigning the note to the seller of the replacement property as partial or full payment towards the purchase price on rare occasions. Depending on the market and their personal aims in selling, the seller of the replacement property may or may not find this to be an appealing offer. In any event, because such an arrangement requires both the buyer and seller to be receptive to such a specific arrangement, it does not happen very often. When this occurs, the QI assigns the note immediately to the seller of the replacement property during the replacement property closing.

HARD MONEY LOANS

Rather than using seller carryback financing, some sellers choose to make an upfront "hard money loan" to the buyer of the relinquished property. Using this option, the seller acts as a third-party lender and places cash in escrow in the amount of the loan. The loan funds are used to purchase the property by the buyer, and the monies are subsequently delivered to the QI for use in the exchange by escrow. While this is a mechanically smoother and easier process, it is crucial to consider the investor's ability to execute their trade. When they provide a hard money loan to the buyer, the funds are transferred to the QI, and if the exchange fails, taxes are due on the entire cash boot (up to the total amount of gains). If, on the other hand, a QI is provided the note at the closure of the relinquished property and the taxpayer's exchange fails, the QI will assign the note back to the taxpayer. Instead of paying taxes all at once, the taxpayer will pay taxes on their gain as they receive payments on the note.

CONCLUSION

If an seller is highly motivated to sell and wishes to exchange, there is no reason why providing seller finance to the buyer should prohibit an exchange from taking place or prevent a taxpayer from collecting the maximum feasible capital gains deferral. To use a seller carryback note in an exchange, the taxpayer or a third-party note buyer must either come up with the cash, the loan term must end within the 180-day exchange period and before the replacement property closes, or the seller of the intended replacement property must agree to let the note be used to buy the new property. Any taxpayer considering inserting a seller carryback note in their exchange should carefully consider all options and speak with their independent tax and legal counsel, as well as their Exchange Officer, before proceeding.

Good Luck & Cheers 

Cameron