When selling properties, there may be times when offering seller carry back financing to a buyer becomes a decisive factor in closing a deal. An investor offering to finance a buyer may wonder if that property can then be used as the relinquished property in a 1031 exchange. The property can, indeed, be used in a 1031 exchange, although the note will need to be converted to cash first, which will complicate the transaction.
Excluding the Seller Carry Back Financing Note from a 1031 Exchange
When an investor has a seller carry back financing note on a property, he or she has the option of excluding it from a 1031 exchange. If that’s done, only the cash portion of the sale will be part of the 1031 exchange. The note will list the investor as the beneficiary and it becomes mortgage boot—debt that cannot be included in the 1031 exchange. Payments on the note are liable to capital gains tax at the time they are received. Thus, if the note is for 10 years, the taxes on it will be spread out over 10 years. Compared to the possibility of paying capital gains tax on that amount in a lump sum, this is a good strategy for exiting real estate.
When there is a seller carry back financing note on a property that is not included in its 1031 exchange, the tax on the depreciation recapture from the property is due in its entirety the year in which the transaction closes.
Including the Seller Carry Back Financing Note in the 1031 Exchange
Including the seller carry back financing note in the 1031 exchange allows the capital gains tax and the tax on depreciation recapture to be deferred. In this case, the note should be made out to the qualified intermediary (QI) that facilitates the exchange. The note can be included in the 1031 exchange in a few ways, all of which entail converting the note into cash. A note can even be included in a reverse 1031 exchange. Plans for these maneuvers should be made in advance and with the assistance of an adviser, however, to make sure that they can be completed in the 180-day timeframe allowed by law.
Remember, if the note has a term of less than 180 days, it can be paid off before the transaction is completed. After that, the simplest way to include the note in the exchange is to buy the note from the QI at face value, leaving the cash in the investor’s account. To avoid boot, the note should be made payable to the investor only after the 1031 exchange has been completed.
Another option, one that may not see a lot of demand, is for the QI to sell the note at a significant discount as a purchase incentive to a third party, and then place the proceeds in the investor’s account. The amount of the discount will have to be deposited with the QI in cash to avoid that sum becoming cash boot—a cash overage on the investor’s side of the 1031 exchange.
An investor can also use the note as part of the payment package for the replacement property. The seller of the property will have to be strongly motivated before accepting a third-party note, however.
Interest on the note is subject to income tax in the year it is received, whether or not the note is included in the 1031 exchange. An additional complication arises when the principal of the note exceeds $5 million. Under IRC 453, which governs installment sales, only $5 million of capital gains tax can be deferred on a seller carry back note. The tax on any amount over that sum will be calculated for the year the deal on the relinquished property is closed. Payment of that tax can then be deferred over the term of the note, but the investor will be charged interest on the deferred amount.
The presence of a seller carry back financing note adds considerable complexity to a 1031 exchange transaction. It is strongly recommended that investors be guided through the process by an experienced adviser.
At CWS Capital Partners, we are a fully integrated multifamily real estate investment management firm that offers everything from due diligence and risk management to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country and employ a team of experts who can help you hone your investment strategy.
For more articles like this one, please see our 1031 exchange blog posts.
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