As interest rates rise and financing gets more challenging, sellers who are motivated to sell may offer to finance a portion of the purchase price. At the closing, the buyer deposits some cash and signs a seller carryback note for the balance. If structured as an installment sale under IRC Section 453, the seller pays tax on any gain as the payments are received rather than paying tax on the gain in the year of sale for the entire purchase price.
If the sellers are also contemplating a tax-deferred exchange under IRC § 1031, they will have to decide how to treat the seller carryback note. The note can either be kept outside of the exchange or, under the limited conditions described below; it can be included in the exchange.
NOTE IS NOT INCLUDED IN THE EXCHANGE
In most cases where there will be seller carryback financing, the note is not included in the 1031 exchange. The note is taxable boot, but the tax is paid over time as the payments are collected. For example, if you sign a five-year note and pay a portion of the principal balance each year, the tax obligation will also be spread out over that five-year period.
When the note is not a part of the exchange, it should be payable to the seller and delivered directly to the seller at the time of closing. Only the cash proceeds received from the sale are delivered to the Qualified Intermediary (QI) and used as exchange funds.
NOTE IS INCLUDED IN THE EXCHANGE
If an investor wants to defer all of the gain in a 1031 exchange, including the amount represented by the note, he has several options. In each case, the note should be made payable to the QI. The QI collects all of the note payments during the term of the exchange, and they become part of the exchange proceeds.
In order for the note to be used as part of the exchange, it must either be converted to cash prior to the purchase of the replacement property or the seller of the replacement property must agree to accept the note as full or partial payment for the property.
