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Seller Carry Back Notes and 1031 Exchanges

You may be requested by real estate buyers from time-to-time to assist them in the acquisition of your real property ("relinquished property") by helping them with the financing.  This means they are asking you to carry back an installment note or promissory note, which is often referred to as "Seller Financing," "Seller Carry Back Financing," or a "Seller Carry Back Note."  It may also take the form of a Land Contract or Contract for Deed.

Seller carry back promissory notes can be very powerful sales tools when negotiating and structuring real estate transactions, especially in rising interest rate environments, distressed real estate markets and tight credit markets.  This type of financing can also be a very effective income tax planning and/or estate tax planning strategy for you if you do not want to 1031 Exchange into other like-kind replacement properties.

Seller Carry Back Note — Inside or Outside the 1031 Exchange

Special planning is required when you intend to complete a 1031 Exchange and carry-back an installment note as part of the 1031 Exchange transaction.

The common misconception is that seller carry-back financing and 1031 Exchanges can not be used together and are mutually exclusive.  This could not be further from the truth.  Seller carry-back financing and 1031 Exchanges are often combined in the same transaction.  They do, however, require careful advanced planning and structuring to ensure a smooth 1031 Exchange transaction.

You must decide prior to the close of your relinquished property sale transaction whether your capital gain income tax consequences related to the seller carry-back note will be deferred under the installment sale rules pursuant to Section 453 of the Internal Revenue Code or pursuant to a Structured Sale drafted pursuant to Section 453 as well, or will be deferred via a 1031 Exchange pursuant to Section 1031 of the Internal Revenue Code

The installment note and deed of trust or mortgage will be drafted differently depending on which strategy you select.  Once the relinquished property sale transaction has closed you can not change your mind, so it is important to meet with your advisors ahead of time to ensure that you make the correct decision for you prior to the close.

Excluding the Note from the 1031 Exchange — Installment Sale Treatment

Should you decide to exclude the seller carry-back note from your 1031 Exchange transaction, the promissory note and the corresponding deed of trust or mortgage would be drafted with you listed as the beneficiary or owner of the promissory note.  Your Qualified Intermediary would only be assigned into the balance of the relinquished property sale transaction that is separate from the seller carry-back note portion of the transaction.  The cash portion or net proceeds from the sale transaction would be sent to your Qualified Intermediary at the close of your relinquished property sale transaction and the installment note would be owned and held directly by you and would not be part of your 1031 Exchange.

The installment note and corresponding deed of trust or mortgage would be taxable under the installment sale rules pursuant to Section 453 of the Internal Revenue Code.  Your capital gain income tax liabilities are deferred over the term of the installment note and would be recognized and taxed as principal payments from the installment note are received by you. 

It is extremely important to note that your depreciation recapture income tax liabilities are not deferred over the term of the installment note, but are actually recognized and taxed in the year in which the relinquished property sale transaction closes.  This can create liquidity issues for you during tax time, so be sure to plan accordingly. 

Not including the seller carry-back note within your 1031 Exchange transaction can be a great exit strategy when you want to get out of real estate altogether but still want to defer your income tax consequences over the term of the installment note.

It is extremely important to remember that your depreciation recapture income tax liability is immediately recognized and taxed in the year of the sale and your capital gain income tax liability is only deferred over the term of the installment note.  

The entire income tax liability would be immediately recognized when the entire outstanding principal balance of the installment note is paid off and received by you.  This can be problematic should the borrower decide to pay off the promissory note early.  You may want to discuss including a prepayment penalty in the promissory note with your advisors.

You may want to consider including the seller carry-back note inside of your 1031 Exchange transaction so that the capital gain and depreciation recapture income tax liabilities can still be indefinitely deferred through your 1031 Exchange.

Excluding the Note from the 1031 Exchange — Structured Sale Strategy

You could also decide to exclude the seller financing from your 1031 Exchange, but to include the seller carry back note inside a Structured Sale. 

Your Qualified Intermediary would only be assigned into the balance of the relinquished property sale transaction that is separate from the seller carry-back note portion of the transaction being processed through the Structured Sale.  The cash portion or net proceeds from the sale transaction would be sent to your Qualified Intermediary at the close of your relinquished property sale transaction.  The seller financing would not be part of the 1031 Exchange transaction.

The Structured Sale would be taxable under the installment sale rules pursuant to Section 453 of the Internal Revenue Code.  Your capital gain income tax liabilities are deferred over the term of the Structured Sale and would be recognized and taxed as principal payments from the installment note are received by you from the Structured Sale. 

It is extremely important to note that your depreciation recapture income tax liabilities may not be deferred over the term of the Structured Sale, but may actually be recognized and taxed in the year in which the relinquished property sale transaction closes.  This can create liquidity issues for you during tax time, so be sure to plan accordingly.

Including the seller carry-back note in a Structured Sale can be a great exit strategy when you want to get out of real estate altogether but still want to defer your income tax consequences. 

You may want to consider including the seller carry-back note inside of your 1031 Exchange transaction so that the capital gain and depreciation recapture income tax liabilities can still be indefinitely deferred through your 1031 Exchange.

Including the Note as Part of the 1031 Exchange — 1031 Exchange Treatment

On the other hand, should you decide to include the seller carry-back installment note as part of your 1031 Exchange transaction, the installment note and corresponding deed of trust or mortgage would be drafted with your Qualified Intermediary listed as the beneficiary or owner under the installment note and corresponding deed of trust or mortgage.  Learn how to properly draft the installment note and deed of trust or mortgage for your 1031 Exchange transaction on our web page entitled "Legal Beneficiary Vesting for Seller Carry Back Notes included with in a 1031 Exchange."

Your entire relinquished property sale transaction will be assigned to your Qualified Intermediary so that at the close of the transaction your Qualified Intermediary will receive all of your net cash proceeds as well as the seller carry-back installment note.  Note payments to be made during the time that the note is held by the Qualified Intermediary must be paid to the Qualified Intermediary. 

The note and corresponding deed of trust or mortgage under this structure would be tax-deferred under the 1031 Exchange rules pursuant to Section 1031 of the Internal Revenue Code.  Your capital gain and depreciation recapture income tax liabilities will be indefinitely deferred as long as you continue to exchange throughout your lifetime.

However, you will find that including a seller carry-back installment note in your 1031 Exchange transaction is much more complicated than structuring the transaction as an all cash 1031 Exchange transaction.

Including the Note as Part of a Reverse 1031 Exchange

Although Reverse 1031 Exchanges are even more complicated and involved, seller carry-back notes may also be utilized within a reverse 1031 Exchange structure depending on your circumstances.  You need to review the proposed transaction with your advisors carefully to determine if a seller carry-back installment note would be of any benefit within your reverse 1031 Exchange.

Complications with Including the Installment Note in the 1031 Exchange

Structuring and closing the relinquished property sale transaction with the seller carry-back installment note included as part of your 1031 Exchange is the easy part.  It gets more complicated from here on out because your Qualified Intermediary is holding more than just cash in your 1031 Exchange account.  How does your Qualified Intermediary use the seller carry-back installment note to acquire your like-kind replacement property?

There are really three (3) potential solutions:

  1. You can use the installment note as part of the consideration paid for the purchase of your like-kind replacement property.  This solution, however, assumes that a seller would be willing to accept the third-party installment note as full or partial consideration their property.  It is a possible solution, but not usually a very practical solution.

  2. You can convert the installment note into cash by selling it to a third party investor.  This could be a viable option, but in most cases the installment note would have to be sold at a significant discount and would not be a practical solution either.

  3. You could contribute additional personal funds into your own 1031 Exchange account equal to the face value of the installment note (boot paid or contributed) so that sufficient cash funds now exist inside your 1031 Exchange in order to complete the acquisition of your like-kind replacement property. 

    The note and deed of trust or mortgage would then be endorsed/assigned to you (boot received) after your 1031 Exchange transaction has been completed.  This structure is probably the most practical provided you have the necessary liquidity to fund the strategy.  It results in the boot received being offset by the boot paid and therefore does not generate any income tax consequences.

Including or excluding the seller carry-back installment note within your 1031 Exchange is not an easy business decision.  In most cases the inclusion of a seller carry-back note with a 1031 Exchange will work if there is sufficient pre-exchange planning to ensure the availability of the proper liquidity to fund the transaction.  And, the inclusion of the installment note usually makes sense from an income tax perspective. 

However, you should decide whether you would even want to accept a seller carry-back installment note as part of your 1031 Exchange transaction, or avoid the headaches involved with a seller carry-back installment note and insist on an all cash transaction for the purchase of your relinquished property.

You should always consult with your legal and tax advisors as well as your Qualified Intermediary prior to completing a seller carry-back installment sale as part of your 1031 Exchange transaction.

Depreciation Recapture Income Tax Issues

The inclusion of the seller carry-back installment note inside your 1031 Exchange transaction will defer the recognition of your depreciation recapture and capital gain income tax liabilities.

Excluding the seller carry-back installment note from your 1031 Exchange transaction will result in the immediate recognition of your depreciation recapture income tax liabilities in the year in which the sale of the relinquished property closed, and your capital gain income tax liabilities will be deferred and recognized over the term of the seller carry-back installment note.

Special Consideration for Installment Sale Notes In Excess of $5 Million

There are special income tax provisions that you will need to take into consideration when the initial principal amount of the seller carry-back installment note exceeds $5 million.

Section 453 of the Internal Revenue Code and Section 1.453 of the Department of the Treasury Regulations allow you to defer the recognition (payment) of capital gain income taxes on the portion of any sale that is financed by you using a seller carry-back installment note.  Your capital gain income tax liabilities are deferred over the term of the installment note and recognized (paid) on a pro-rata basis as principal payments are made against the installment note.

However, if the original principal balance of the seller carry-back installment note exceeds $5 million, you can only defer the recognition of the capital gain income tax liabilities on the first $5 million.  The remaining capital gain income tax liabilities related to the balance of the installment note that exceed $5 million will be recognized in the year in which the sale of the relinquished property transaction closed.  Although this portion of the capital gain income tax liability will be recognized immediately, the IRS will allow you to defer the actual payment of the income tax liabilities over the term of the note and will assess interest on the deferred income tax liability.

Other Income Tax Considerations

Interest income earned on your seller carry-back installment note is taxable as ordinary income, and is taxable to you in the year in which the interest income is paid to the holder of the note whether the installment note is included or excluded as part of your 1031 Exchange.

The holder of the note is generally responsible for filing IRS Form 1098 that will report the amount of interest paid by the borrower to the IRS.  The servicing agent or collection agent is generally responsible for filing IRS Form 1099INT that will report the amount of interest income received by you as the lender under the seller carry-back installment note. 

 

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