Sellers are sometimes asked to provide financing to the buyer of their property as part of the sale negotiations. Usually structured with payments spread out over a number of years, sellers can report the transaction as an installment sale under Section 453 of the tax code. The installment sale method would allow the seller to defer the gain over the life of the note. Taxes are paid based on the payments received each year and part of each payment is the return of your basis, part is your capital gain which will be taxed according to capital gains tax rates and the interest paid is treated as ordinary income.
When completing a 1031 exchange, providing seller financing to the buyer of the relinquished property creates a problem because receiving anything other than like-kind replacement property is taxable. With planning, there are several ways to make the seller financing work while still deferring all gain in your exchange. In all cases, the note must be between the buyer of the relinquished property and the Qualified Intermediary (QI). All payments on the note must be made payable to the QI and be deposited into the exchange account for the benefit of the Exchanger.
The ways to structure the selling financing so it can work in a 1031 exchange are as follows:
- Sometimes the buyer just needs short-term financing until their permanent financing can be secured. The seller financing can be structured with a short-term due date prior to the scheduled closing of the replacement property.
- Using out of pocket funds, the Exchanger could purchase the note from the QI for the outstanding balance. The QI will deposit the funds into the exchange account and the Exchanger will have all funds available for the acquisition of the replacement property. This would have to happen before the replacement property can be acquired. The note will be assigned to the Exchanger and the Exchanger will receive all subsequent payments and be able to report the note as an installment sale.
- The note can be sold on the open market and the funds deposited into the exchange account before the Exchanger acquires the replacement property. Unfortunately, the Exchanger will likely be unable to sell the note for the full amount and will have some taxable “boot.”
- The Exchanger can negotiate with the seller of the replacement property to take the note as part of the consideration for the replacement property. While it doesn’t happen often, when interest rates are low and other investments are not earning much of a return, this note could provide a steady dependable income stream to the seller and it is tax-deferred over the life of the note.