Installment Sales & 1031s:
Successfully Working Together
While it is a Seller’s market again, there are still plenty of instances when a Buyer asks the Seller to provide financing. Whether the Buyer needs a swing loan until permanent financing is secured or if they are asking the Seller to provide that long-term financing, seller financing can be a win-win for both the Seller and Buyer.
The Seller, A/K/A the Exchanger, is able to get the sale closed at the price they want and could have a good investment vehicle with a steady return for an agreed upon term. The Buyer is able to secure the financing they need without losing the desired property. If the property is held for business use or investment and the Seller wishes to defer the gain through a 1031 exchange, he/she will need to do some planning to maximize the tax-deferral because the amount of the seller financing cannot be deferred through the exchange.
With planning, there are several ways to successfully maximize the tax-deferral even when providing seller financing but in order to use any of these options the Note must be between the buyer and the Qualified Intermediary (QI) and all payments must be made payable to the QI. The options are as follows:
- The Exchanger could buy the Note from the QI so the funds can be deposited into the 1031 exchange account and available for acquisition of the replacement property. This can be done anytime during the exchange period before the replacement property is acquired.
- The Note is due within 180 days of Buyer’s acquisition of the relinquished property so all funds can be deposited into the exchange account before the Exchanger is ready to acquire the replacement property.
- The Seller of the replacement property can take the Note as part of the consideration for the replacement property. Yes, this does actually happen sometimes!
- The Note can be sold on the open market and the funds deposited in the exchange account before the Exchanger is ready to acquire the replacement property. Keep in mind that when a Note is sold, it is typically purchased at a discount.
If the Exchanger does not think any of the options mentioned above are viable, he/she can structure a combination 1031 exchange/installment sale. Under Section 453 of the tax code, you can defer the gain over the life of the Note as long as at least one payment is received in the following tax year. Taxes will only be due based on the amount received each year. An installment sale can provide a steady income stream and you can work with your tax advisor to minimize the tax consequences.
With this structure, the Note is between the Exchanger (Seller) and Buyer. All payments will be paid directly to the Exchanger and the amount of this Note will be excluded from the 1031 exchange. This structure can be especially advantageous when the Exchanger is trading down in value and will realize some gain.
Whenever contemplating seller financing in a 1031 tax-deferred exchange, you should always discuss the tax consequences with your tax advisor so you can determine the best way to proceed in your particular situation but it may just be the ideal solution for you.