Owner Carry Financing in a 1031 Exchange
– Installment Sales under IRC Section 453 –
Investors often ask us if owner carried financing (installment sales under IRC section 453) and a 1031 exchange (IRC section 1031) work together in the same transaction. While possible, it can be tricky adding owner carry financing to a tax-deferred exchange. Before we dive in, here are a few things to keep in mind:
- Receipt of a promissory note could trigger immediate tax boot in your 1031x;
- Moreover, you may put yourself in position to face immediate recognition of all of your recaptured depreciation.
Let’s start with the basics; later, we’ll explain how to best navigate an owner-carry situation.
What is “owner carry financing”?
In real estate transactions, the owner of a property may decide to help the buyer finance the purchase. Effectively, this means the buyer borrows money from the seller rather than (or in conjunction with) traditional lending sources.
Also known as “seller financing,” this is a popular option when the buyer has trouble meeting other lender guidelines. Carry-back notes are sometimes useful when facing buyer’s markets or rising interest rates.
For any given owner-carry loan, the buyer and seller will negotiate the terms (interest rate, payment schedule, etc.), and the buyer will provide the seller with a promissory note.
*You can find a link to a primer on owner financing at the bottom of the article.
Tax treatment for owner carry financing within a 1031
You may read elsewhere that seller or owner financing cannot be used in a 1031 exchange. Happily, this is not true. Owner-carry deals occur within 1031 transactions with some frequency; the key is to ensure you plan appropriately and not run afoul of IRS rules.
Important tax considerations
- In the simplest form, IRC section 453 applies to the owner carry portion of the transaction.
- IRC section 1031 applies to the rest of the deal.
- Recognition of income is delayed on the installment portion; you only report income received from installment payments in a given calendar year**
- Any interest earned on an owner carry-back loan is taxable as ordinary income in the year when you receive the interest.
- You must report interest paid by the borrower on IRS Form 1098.
- It is possible to defer recaptured depreciation taxes on the installment note portion**
**Correctly drafting the note and deed of trust is crucial. We go over these details below in the Strategy section.
Problems with owner carry financing
There’s a catch here, and it’s related to the receipt of the promissory note. As the 1031 regulations state
“If the taxpayer actually or constructively receives such proceeds before the taxpayer actually receives the like-kind replacement property, the transaction will constitute a sale, and not a deferred exchange, even though the taxpayer may ultimately receive the like-kind replacement property.”
Two things are important to identify here:
- The IRS defines “such proceeds” to include a promissory note;
- Sale proceeds that are not counted in a deferred exchange are fully taxable.
Unfortunately, 100% of the recaptured depreciation is recognized (paid) and the tax basis in the owner carried note is equal to the tax basis in the relinquished property or the face amount of the note, whichever is less.
These are both serious downsides to combining owner carried financing with a 1031x. Fortunately, you can mitigate or avoid these downsides.
Better strategies for your 1031 exchange
These strategies are presented in the order which we prefer. In each case, consider a scenario where your buyer is asking for $200,000 of seller carry financing to close the deal:
1. You bring cash to make up the difference
If financially able, you substitute new cash financing for the owner-carried note. That new cash — now a lump-sum and not coming as installments — goes into your 1031x escrow account. In effect, you cover the difference ($200,000) that the buyer is asking for, which allows you to show the IRS that 100% of the money in the sale went directly through your escrow account and toward the purchase of valid 1031x replacement property.
Acting as the lender, you now bring the full amount of cash (the face value of the note) to the closing table. A promissory note and deed of trust would be executed between you and the buyer.
Again, now the full balance of the 1031 exchange is immediately available after the sale and is ready to be used for the replacement property purchase. This strategy is doubly beneficial:
- The 1031x is completed in an entirely tax-deferred way (including deferral of recaptured depreciation).
- The tax basis in the note is now its face amount instead of a carried over basis from the relinquished property. This is the best/easiest option for completing the 1031 exchange, but it requires that you have the financial means available!
2. Draft the note as payable to the 1031 intermediary (version 1)
Instead of providing new cash as a loan, an alternative is to have the owner-carried note made payable to your 1031 intermediary at closing. Using this method, your intermediary receives all of the net cash proceeds (into your 1031x escrow account) as well as the note for $200,000.
During the next 180 days and prior to purchase of the replacement property, have your 1031x intermediary sell the note back to you (or a close friend or family member) at full value and add the sale proceeds into the 1031x account.
Now, you can use the entire cash amount as the down payment on the replacement property. The full tax benefits described in Strategy 1 still apply here.
3. Draft the note as payable to the 1031 intermediary (version 2)
Very similar to Strategy 2. Again, make the owner-carried note payable to your intermediary at closing. Then, during the next 180 days and prior to purchase of the replacement property, direct the intermediary to sell the note to an unrelated third-party buyer.
The sale proceeds and new loan proceeds ($200,000) go into the 1031x escrow account. You still use the entire amount as the down payment on the replacement property. Similar tax benefits as set forth in Strategy 1 apply to this strategy.
What’s different here? Selling the note to a third-party on the secondary market often requires a discounting of its sale price below the face amount of the note. In effect, you could find yourself rushed into accepting a poor trade because of closing 1031x timelines.
It is theoretically possible to include the note as part of your replacement purchase. With this option, the corresponding seller would need to accept the note as partial “consideration paid” for their property. In our experience, this is highly unlikely.
4. Exclude the note and deed from the 1031 exchange
Suppose none of the prior strategies seem viable. In this case, the last option is to exclude the owner carry note from the 1031 transaction. You only assign to your 1031 intermediary the portion of your relinquished property sale that is not part of the $200,000 owner carry. The remainder of the net sale proceeds will be part of your exchange and go to your 1031x escrow account.
In this case, you are the beneficiary of the installment note and deed of trust. The note is taxable pursuant to Section 453. You still enjoy some deferral of income tax liabilities during the term of the note (due when the buyer pays off the note), but your depreciation recapture liability is immediately recognized.
This could put you in a spot where you owe thousands of dollars in taxes to the IRS but are cash-poor because you don’t have access to the proceeds of your relinquished property sale.
Final thoughts on carry-back notes and 1031x
If you improperly structure an owner carry, you can face two bad consequences:
- You have to pay recaptured depreciation tax right away;
- The basis in the relinquished property becomes your basis in the note. That means that some of every principal payment (plus all of the interest) will be taxed.
Compare that to a new cash loan from you to the buyer:
- No recaptured depreciation;
- Your tax basis in the note is the face amount of the note, so none of the principal repayment is taxed;
- The cash that you lend the buyer goes straight into a 1031x account and you use it to buy replacement 1031x property.
This is a nuanced and complicated issue. If you want to explore seller financing, make sure you speak with professionals who can walk you through the process safely. 1031x.com, Inc. always works to maximize our client’s tax efficiencies.
How can we help you? Click here to contact a 1031 exchange specialist or call (303) 504-0144 for a free consultation.
A Guide to Owner Financing (the balance)
Hub for 1031 Exchange Strategies (1031x.com)
26 U.S. Code § 453. Installment method (Cornell Law)
1031 tax calculator (1031x.com)