By Steve Chacon
Occasionally sellers are approached with the request they carry back an installment note to finance the purchase. Not a bad idea from a “big picture” perspective, as seller financing has been effective in environments where credit is a concern and interest rates are rising. But is it possible to include a carryback financing note in §1031 exchange installment sale, and how will it impact the process?
§1031 Exchanges Combined with Seller Carryback Notes
While it is possible to include the seller carry back note in the exchange, careful consideration must be made.
Upon settlement of the relinquished property, both the cash proceeds and the promissory note must go into the exchange account. This is a two-step process; first, the cash portion is wired directly to the qualified intermediary’s bank to be placed in a separate account on behalf of the exchanger.
Second is the note. While the terms will be negotiated between the exchanger and the buyer, the actual language will name the qualified intermediary as the “obligee/beneficiary” and the buyer as the “obligor”. All related security documents should be drafted in the same manner. Payments on the note should be delivered directly to the qualified intermediary and deposited with the rest of the sale proceeds in the exchange account. All three items — the initial cash proceeds, the promissory note, and the payments received — will remain with the qualified intermediary until the exchanger is ready to purchase a properly identified replacement property(ies).
Importantly, if after settlement, the promissory note incorrectly names the exchanger as the beneficiary, it cannot be corrected. The IRS will treat the note as taxable “boot” and look for installment sale treatment with recognition of depreciation recapture.
When the exchanger is ready to purchase properly identified replacement property(ies), the qualified intermediary wires the necessary amount from the exchange account to settlement.
Additionally, in an exchange that includes seller financing, the exchanger must take an active role before closing by doing one of the following:
Deliver funds equal to the payoff balance of the note to the qualified intermediary. The intermediary will then endorse the note and related security documents tot he exchanger. The initial proceeds and new note proceeds will then be wired as consideration to purchase the replacement property(ies). The IRS will require the note received be treated as taxable “boot received” by the exchanger, but the cash paid for the note may be used to offset that amount as “boot paid,” thereby eliminating any tax due.
Negotiate the sale of the note to a third party buyer and convert it into cash. The note then moves from the qualified intermediary to the third party buyer and the sale proceeds are delivered directly to the exchange account. The entire cash amount, both initial proceeds and note proceeds, will be wired as consideration to purchase the replacement property(ies).
Instruct the qualified intermediary to endorse the note and related security documents to the seller of the replacement property(ies). The exchanger will need to negotiate with the seller to include the note as consideration for the purchase of the replacement property(ies).
The decision to include seller financing in a §1031 exchange with installment note can be difficult. If you are considering seller financing, be sure to select an experienced qualified intermediary who understands the process and has been through it before. And always seek advice from your tax advisor and financial planner to ensure the transaction is complete smoothly, successfully and that it dovetails with your larger financial picture.
Steve Chacon is Chief Operating Office of Malbur Exchange Group and Associates, LLC (MEGA 1031) and can be reached at 866-881-1031.
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