Seller Financing... Useful Strategies in a 1031 ExchangeFirst American Exchange Company
June 18, 2009 — 1,440 views
In the current lending environment seller financing may be an option that benefits both the buyer and the seller.
When an Exchangor sells property and wants to provide seller carryback financing to the buyer and also take advantage of the tax deferral of a 1031 exchange, the Exchangor has several options.
1. The Exchangor can elect not to include the note in the 1031 exchange. The Exchangor would be listed as the beneficiary on the note at the closing of the transaction and would pay taxes on the note over time as described under the installment sale provisions under Section 453 of the Internal Revenue Code, or
2. The Exchangor can include the note in the 1031 exchange. In order to accomplish this, at the closing of the sale, First American Exchange Company must be listed as the beneficiary on the note. Under this method, the Exchangor has numerous choices regarding how they can relieve themselves of the note through the 1031 exchange process, and still defer their capital gain liability. In any event, the Exchangor must either use the note to buy the replacement property or convert the note to cash before acquiring the replacement property in order to be able to get 1031 tax deferral on the value of the note.
- The Exchangor could use the note as a partial payment on their replacement property. To do this, the Exchangor must find a seller who is willing to take the note as consideration towards their purchase price. The note would be assigned from First American Exchange Company to the seller at closing.
- The note may be paid off by the buyer of the relinquished property before the Exchangor purchases replacement property. This option only works when the note is due to be repaid in less than 180 days. In this case, the buyer pays off the note directly to First American Exchange Company, the holder of the note. First American Exchange Company receives these funds and deposits them into the Exchangor's 1031 account, giving the Exchangor cash to purchase their replacement property.
- The Exchangor can cause a related party to acquire the note by loaning said party cash equal to the amount of the note which is then deposited with the settlement agent on or prior to the date the replacement property closes. At the closing, the note will be assigned to the related party and the cash loaned to buy the note will be available to acquire the replacement property.
- The Exchangor may sell the note on the secondary market. If the Exchangor can find someone who is willing to purchase the note from First American Exchange Company, First American assigns the note to the buyer of the note, and the buyer deposits cash into the Exchangor's 1031 account. Normally, an Exchangor who will purchase the note will purchase it only at a discount, sometimes 20% - 30% below the note's value. If such a discount occurs, some tax professionals will classify the discount as a selling expense.
If an Exchangor initially chooses to have the carryback note payable to First American Exchange but is unable to convert the note to cash or use it to acquire the replacement property, at the end of the exchange, First American Exchange Company will assign the note to the Exchangor. The Exchangor will receive payments under the note and the applicable taxes will be due upon receipt of each payment. Some of these payments may be taxed under the installment sale provisions of Internal Revenue Code Section 453, so please consult with your tax professional for specific information.