Using Seller Carry Back Financing on Sale of 1031 Investment Property

Real estate investors often need to think outside of the box and look for creative solutions when trying to sell 1031 investment property, especially in challenging real estate markets. Prospective buyers may have difficultly in obtaining financing for the purchase of 1031 investments. The real estate seller may need to step forward and help with the financing in order to complete the sale of the investment property.

Seller Carry Back Financing

One creative solution is using a seller carry back note or seller financing to help structure the sale of the 1031 exchange relinquished property. The real estate seller functions as a lender by lending money to the buyer by taking back an installment note at the closing of the 1031 property.

The real estate seller is still protected because the seller carry back note is secured by the 1031 exchange relinquished property. The seller would merely foreclose against and take the 1031 investment property back if the buyer fails to make good on the note.

Of course, the real estate seller should always try to structure an all cash transaction with no seller carry back financing. Seller financing will always complicate the sale of investment property, especially when the seller is also structuring a IRS 1031 tax deferred exchange.

Complications with Seller Financing in a 1031 Investment Exchange

The challenge with seller carry back financing in a real estate 1031 exchange is that the real estate investor ends up with some cash as well as the installment note. The installment note is not liquid and can not be readily converted into cash.

The real estate investor must make a decision as to what to do with the seller carry back note. While seller carry back financing does work within a 1031 exchange, it also significantly complicates the 1031 transaction and can limit the investor’s flexibility in completing the 1031 deferred exchange.

Seller Financing Options within a 1031 Tax Deferred Exchange

There are a number of strategies available to the 1031 investor when a seller carry back note must be used in a IRS 1031 deferred exchange transaction.

1. Sell the 1031 investments with seller financing and decide not to complete a 1031 exchange. Some of the income taxes will be deferred over the term of the installment note. Depreciation recapture taxes are due in the year the 1031 investment property was sold.
2. Sell the investment property with seller financing and complete a 1031 tax exchange but keep the note outside of the 1031. The note can be “carved out” and structured outside of the 1031 tax free exchange transaction and the balance of the cash would be structured inside of the 1031 tax deferred exchange. Depreciation recapture and some of the capital gain taxes will be recognized in the year the 1031 relinquished property was sold. The rest of the capital gain taxes will be deferred over the term of the installment note.
3. Sell the 1031 investment property, carry back an installment note and complete a 1031 exchange with the note inside the 1031 exchange. The note and cash would be included inside the 1031 deferred exchange. The note must be used to pay for the 1031 replacement property, which generally means it must be converted into cash. Income taxes are 100% deferred through the 1031 tax exchange.

There are three options that may work within this strategy:

1. Assign the note to the seller of your 1031 replacement property as part of the consideration for the property.
2. Sell the installment note for cash. This often results in the sale of the note at a discount, which can be very expensive.
3. The real estate seller can contribute additional out-of-pocket cash equal to the face value of the note in order to complete the 1031 tax exchange. The installment note will be assigned to the real estate investor after the 1031 tax free exchange has been completed.

Including or excluding the seller financing in your 1031 tax exchange is not an easy decision. In most cases the inclusion of the installment note with a deferred 1031 exchange will work if there is adequate pre-exchange planning to make sure there is adequate cash to replace the note with.

And, the inclusion of the installment note usually makes sense from an income tax perspective because your depreciation recapture and 1031 capital gain taxes are 100% deferred.

Consult with Legal and Tax Counsel

Seller carry back notes create significantly income tax complexities. Real estate investors should always consult with legal and tax counsel prior to attempting any of these 1031 strategies when purchasing a 1031 investment.

About the Authors:

Exeter 1031 Exchange Services, LLC is a leading national provider of comprehensive 1031 exchange services, which include forward, reverse, and improvement 1031 exchange strategies

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