1031 Exchanges Part 4 – Using Seller Financing

By BPE Law Attorney Matthew Kirkpatrick

When the purchaser of the downleg property cannot obtain financing to complete the transaction, the seller/taxpayer may want to do a seller carry back transaction. Can it be done? Unless certain precautions are taken, the taxpayer’s promissory note or any payments received thereunder would be considered property “not solely in kind” and “shall be recognized, but in an amount not in excess of the sum of such money.” IRC §1031(b). The taxpayer can either include the promissory note financing the transaction in the IRC §1031 exchange or handle it separately.

a. Exclude the Note
If the note is excluded from the exchange the note is not of a like kind as the downleg property and income will be recognized according to IRC §453 under the rules for Installment Sales where payment of the purchase price are made in multiple “installments”. . The general rule is that “income from an installment sale shall be taken into account…under the installment method.” IRC §453(a). An installment sale occurs when there is “a disposition of property where at least one payment is to be received after the close of the taxable year in which the disposition occurs.” IRC §453(b)(1).

If any amount of the Note is paid after the taxable year in which the taxpayer receives the downleg property, the installment method will be used unless the “taxpayer elects to have [the installment method] not apply to such disposition”. IRC §453(d)(1). Under the installment method, payments received through a promissory note are recognized in the taxable year they are received and not in the year that the property is sold. Therefore, the taxpayer could defer the recognition of payments under the note, but they will be recognized….and taxed!

b. Include the Note
Alternatively, The promissory note can also be included in the 1031 exchange in one of four ways, all of which require the use of a qualified intermediary to act in a capacity similar to an escrow account. In all cases, the note must be payable to the qualified intermediary and not the taxpayer. This is crucial because if the taxpayer actually or constructively receives money or other property in the full amount of the consideration for the relinquished property before the taxpayer actually receives like-kind replacement property, the transaction will constitute a sale and not a deferred exchange, even though the taxpayer may ultimately receive like-kind replacement property.” Regs. §1.1031(k)-1(f)(1). The taxpayer “is in actual receipt of money or property at the time the taxpayer actually receives the money or property or receives the economic benefit of the money or property.” Regs. §1.1031(k)-1(f)(2). The taxpayer”is in constructive receipt of money or property at the time the money or property is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon it at any time or so that the taxpayer can draw upon it if notice of intention to draw is given.” Regs. §1.1031(k)-1(f)(2).

The use of a qualified intermediary will avoid actual or construction receipt of the property under any of these four methods:

(1) Full Payment within the Exchange Period
The first method involves the seller paying the full amount of the note within the exchange period. In this case, the taxpayer transfers the downleg property to the qualified intermediary while at the same time the buyer transfers the note and any cash payment to the qualified intermediary. During the exchange period the buyer pays the full amount of the note to the qualified intermediary. The qualified intermediary then transfers the downleg property to the buyer. Next, the qualified ntermediary uses the payments from the buyer to purchase the upleg property from the seller. Lastly, the qualified intermediary transfers the upleg property to the taxpayer. This only works in the case where the buyer only needs a short term loan from the taxpayer.

(2) Sale of the Note to a Third Party
In the next method, the qualified intermediary sells the note to a third party for cash, likely on a discounted basis. The taxpayer transfers the downleg property to the qualified intermediary while at the same time the buyer transfers the note and any cash payment to the qualified intermediary. The qualified intermediary then sells the note to a third party on the open market. The qualified intermediary then transfers the downleg property to the buyer. next, the qualified intermediary uses the cash from the sale of the note to purchase the upleg property from the seller. Lastly, the qualified intermediary transfers the upleg property to the taxpayer.

(3) Seller Assumes the Note
In the third type of transaction, the seller assumes the note in exchange for the upleg property. The taxpayer transfers the downleg property to the qualified intermediary while at the same time the buyer transfers the Note and any cash payment to the qualified intermediary. The qualified intermediary then transfers the downleg property to the buyer. Next, the qualified intermediary assigns the note to seller to purchase the upleg property from the seller. Lastly, the qualified intermediary transfers the upleg property to the taxpayer.

(4) Taxpayer Pays the Face Value of the Note
The last method involves the taxpayer purchasing the note from the qualified intermediary. The taxpayer transfers the downleg property to the qualified intermediary while at the same time the buyer transfers the Note and any cash payment to the qualified intermediary. The qualified intermediary then transfers the downleg property to the buyer. Next, taxpayer pays the qualified intermediary the face value of the note and in exchange the qualified intermediary assigns the Note to taxpayer. The qualified intermediary uses the funds received from the buyer as well as the taxpayer to purchase the upleg property from the seller. Lastly, the qualified intermediary transfers the upleg property to the taxpayer.

Certainly these rules are detailed and confusing, but the benefits of a successful 1031 Exchange can be well worth the effort. An experienced well qualified intermediary is a must.

If you would like to know more, please feel free to contact Matt by e-mail to mjkirkpatrick@bpelaw.com or call our main office at 916-966-2260 to schedule a low-cost Consultation appointment either in our Fair Oaks or Sun City Lincoln office.