Every so often sellers are approached with the request they carryback an installment note to finance the purchase. Not a bad idea from a “big picture” perspective as seller financing has been effective in environments where credit is a concern and interest rates are rising. Positive results of this strategy have also been seen in areas of individual, estate, and business tax planning. What about §1031 Exchanges? Is it possible to include a carryback note, and how will it impact the process?
Remember that planning is of the utmost importance and, while it is possible to include the seller carryback note in the exchange, careful consideration must be made. Be sure you are working with an experienced qualified intermediary that understands the process and has been through it before. Also, remember to involve your current tax and financial advisors. Meeting with your team prior to settlement will ensure the process is structured correctly and that it dovetails with your larger financial picture.
Upon settlement of the relinquished property, both the cash proceeds and the promissory note must go into the exchange account. This is a two-step process; first the cash portion is wired directly to the Qualified Intermediary’s bank to be placed in a separate account on behalf of the Exchanger. As for the note, while the terms will be negotiated between the Exchanger and the Buyer, the actual language will name the Qualified Intermediary as the “Obligee/Beneficiary” and the Buyer as the “Obligor”. All related security documents should be drafted in the same manner. Payments on the note should be delivered directly to the Qualified Intermediary and deposited with the rest of the sale proceeds in the Exchange Account. All three items: the initial cash proceeds, the promissory note, and the payments received, will remain with the Qualified Intermediary until the Exchanger is ready to purchase a properly identified replacement property(ies). It is very important to remember, if after settlement, the promissory note incorrectly names the Exchanger as the beneficiary, it cannot be corrected. The Internal Revenue Service will treat the note as taxable “boot” and classify that portion as an installment sale.
When the Exchanger is ready to purchase properly identified replacement property(ies), applying the cash proceeds is fairly simple. The Qualified Intermediary wires the necessary amount from the Exchange Account to settlement. However, in an exchange that includes seller financing, how does the Qualified Intermediary move the remaining balance of the note from the Exchange Account into the replacement property(ies)? This step requires the Exchanger to take an active role before closing, by doing one of the following:
- Deliver funds equal to the payoff balance of the note to the Qualified Intermediary. The Intermediary will then endorse the note and related security documents to the Exchanger. The initial proceeds and new note proceeds will then be wired as consideration to purchase the replacement property(ies). The Internal Revenue Service will require the note received be treated as taxable “boot received” by the Exchanger, but the cash paid for the note may be used to offset that amount as “boot paid”, thereby eliminating any tax due.
- Negotiating the sale of the note to a Third Party Buyer and converting it into cash. The note then moves from the Qualified Intermediary to the Third Party Buyer and the sale proceeds are delivered directly to the Exchange Account. The entire cash amount, both initial proceeds and note proceeds, will be wired as consideration to purchase the replacement property(ies).
- Instruct the Qualified Intermediary to endorse the note and related security documents to the Seller of the replacement property(ies). The Exchanger will need to negotiate with the seller to include the note as consideration for the purchase of the replacement property(ies).
In light of the above, the decision to include seller financing in a §1031 Exchange can be difficult. Whether or not you are considering seller financing, always seek input from your Tax Advisor, Financial Planner and Qualified Intermediary. By coordinating communication among these professionals, you can be sure the transaction is completed smoothly and successfully. Malbur Exchange Group and Associates, LLC (MEGA 1031) is highly experienced in exchange matters involving seller financing. Steve Chacon is MEGA 1031’s Chief Operating Officer and can be reached at 866-881-1031.