NAVIGATING SELLER FINANCING IN 1031 EXCHANGES: STRATEGIES AND CHALLENGES

By Juno Kenny, VP, Exchange Manager, Genesis Bank Exchange

With interest rates remaining high, seller financing continues to be an attractive option for real estate investors nationwide. Because of this, we will outline some of the issues that arise when offering seller financing while performing a 1031 Exchange. While it can be done, you must plan accordingly beforehand to avoid any potential missteps.

The first decision that must be made when offering seller financing is whether to include the seller carry-back installment note as part of the exchange or not.

Installment Sale Method – Excluding the Note from the 1031 Exchange

If you decide to exclude the seller carry-back note from your 1031 Exchange, the Qualified Intermediary would only be assigned into the balance of the relinquished property sale transaction that is separate from the seller carry-back note portion of the transaction. The installment note would be owned and held directly by you and would not be part of your 1031 Exchange.

1031 Exchange Method – Including the Note in the 1031 Exchange

Alternatively, if you decide to include the seller carry-back installment note as part of your 1031 Exchange transaction, your entire relinquished property sale transaction would be assigned to your Qualified Intermediary, so at the close of the transaction, your Qualified Intermediary would receive all of your net cash proceeds as well as the seller carry-back installment note.

However, including a seller carry-back installment note in your 1031 Exchange transaction is more complicated than structuring the transaction as an all-cash 1031 Exchange transaction due to issues that arise when the replacement property is purchased.

Purchasing Issues

Now that the Qualified Intermediary is holding the sale proceeds as well as an installment note from the Buyer of the relinquished property, the problem is that the Qualified Intermediary/Exchanger needs to use the installment note to purchase a replacement property.

Potential Solutions

There are four potential solutions to this problem.

1. Contributing personal funds to cover the balance of the note. If you have the required funds available, covering the balance of the note with personal funds tends to be the most popular option. By contributing personal funds to the exchange account, the boot received from the installment note is offset and does not trigger a taxable event.
2. Using the note to purchase a replacement property. This assumes that the Seller of the replacement property will accept the third-party installment note as payment. While this is a potential solution, it requires a high level of cooperation between the Buyer and Seller, which is not guaranteed in any case.
3. Converting the installment note into cash. This typically requires the note to be sold at a significant discount, leaving it open as an option, but typically, it is one reserved for a worst-case scenario.
4. Assigning the note back to the exchanger. In the event that the exchanger decides not to include the note in the exchange, the note can be assigned from the QI back to the exchanger. In this case, the note would be considered taxable boot not eligible for 1031 treatment and would be distributed to the exchanger once the exchange is complete.

As you can see, it is possible to offer seller financing and complete a successful 1031 Exchange. However, to do so requires careful planning and an understanding of the potential risks involved.

If you’re interested in learning more about the 1031 exchange process and how it may benefit you, connect with the Genesis Bank Exchange team by calling 800.797.1031, or explore further details on our website: https://www.mygenesisbank.com/1031Exchange.