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1031 Exchange and Seller Financing
As interest rates continue to rise we expect to see more seller financing (or seller carry backs) taking place. The motivation for a seller to carry back a note in exchange for their property typical is to facilitate a transaction that would not have happened with conventional financing at the price they are asking.
Outside of the possibility of taking back the property if the new owner defaults on the note carried, is the impact that a loan for the property will have on the sellers taxes.
If not structured carefully the seller will end up paying capital gains taxes on the money being paid back as the loan is being paid off. If the seller plans carefully the issues around unwanted taxes can be addressed to the seller’s advantage and still to a seller carry back.
Some possible solutions to the potential tax liability created by a seller carry back are as follows:
1. Assign The Note to the Seller of the Replacement Property: If the seller of the replacement property will accept the Note as a portion of the consideration for the property to be acquired, this will allow the amount of the Note to be included in the exchange.
2. Sell The Note: The Exchanger can sell the note to an outsider, investor, or relative, as long as the funds go directly to escrow, or to the Qualified Intermediary. The funds will then be used to purchase the replacement property.
3. Buy the Note: If the Exchanger has funds outside of the exchange with which to purchase the Note, (replacing the Note with cash in the exchange account), the Note will be Assigned to the Exchanger, who can then collect on the Note. This will usually result in the exchanger paying taxes only on the interest received.
Please be aware that in order to execute any of the above strategies and qualify for a 1031 exchange any decision being made regarding a Seller Carry Back must be made prior to the closing of escrow of the property to be relinquished. Also, the note should be drawn to reflect the Qualified Intermediary as the beneficiary who can then assign it to the appropriate entity.
Please consult your CPA and real estate attorney for tax related advice and, to assure the contracts involving your sale are properly drafted.
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