Seller Financing in a 1031 Exchange: What Happens to the Carryback Note

Buyers who cannot get full bank financing sometimes ask the seller to carry part of the purchase price. Instead of receiving all cash at closing, you receive a promissory note, paid over years with interest.

For an ordinary seller, that can be an attractive installment sale. For a seller doing a 1031 exchange, it creates a problem. The Qualified Intermediary needs cash to buy replacement property. A note is not cash, and whatever the note represents may end up treated as boot.

Why does seller financing complicate an exchange?

To defer all gain, you generally have to reinvest all the net proceeds of the sale into replacement property of equal or greater value.

If part of the price is paid by a note, the intermediary receives less cash. If you cannot make up the difference, you buy less replacement property, and the shortfall is taxable. The note itself also represents value you received that is not like kind property. Left alone, it is boot.

The good news is that boot in the form of a note can often be reported on the installment method, so tax is paid as principal payments are received rather than all at once. That softens the problem but does not remove it.

How can the note be kept inside the exchange?

There are several established approaches, and the right one depends on how much cash you have and what the replacement seller will accept.

Make the note payable to the intermediary. The note is issued to the Qualified Intermediary as part of the exchange proceeds, rather than to you personally. It then needs to be converted into value that can be used for the replacement purchase.

Sell the note for cash before the replacement closes. The intermediary sells the note to a third party, usually at a discount, and uses the cash to buy replacement property. The discount is a real cost, but it may be cheaper than the tax.

Buy the note from the intermediary with your own cash. You pay the intermediary the face value of the note using outside funds. The intermediary now has full cash for the purchase, and you hold the note personally. Because you replaced the note with your own money, the exchange can be complete.

Have the buyer pay off the note within the exchange period. If the buyer is refinancing soon, the note may be paid in full before day 180, with the cash going to the intermediary.

Use the note as part of the replacement purchase. In some cases the seller of the replacement property will accept the note as part of the price. That requires a willing counterparty and careful drafting.

What are the risks?

The buyer's credit. A note is only as good as the person paying it. If the buyer defaults, you may have paid tax on value you never receive, or you may have to foreclose and take the property back.

The discount. Notes typically sell below face value, especially at low interest rates or with weaker buyers. That reduces the effective sale price.

Timing. All conversions must be completed within the exchange deadlines. A note that cannot be sold or paid off in time becomes boot.

Documentation. The note must be structured correctly from the start, with the intermediary involved in the drafting. Fixing it after closing is far harder.

When is seller financing still worth it?

When it is the only way to achieve a sale at the right price, or when the seller actually wants income from the note and is willing to recognise part of the gain over time.

In those cases, a partial exchange can be sensible: reinvest the cash portion through the intermediary to defer that part of the gain, and report the note as installment sale income. The seller gets deferral on most of the proceeds and a steady stream of payments on the rest.

What does a worked example look like?

Suppose you sell a property for 2 million dollars. The buyer pays 1.5 million in cash and gives a 500,000 dollar note. Your intermediary receives 1.5 million.

If you buy a 2 million dollar replacement property, you need 500,000 dollars from somewhere. Option one is to buy the note from the intermediary with 500,000 dollars of your own cash. The intermediary now has 2 million, the exchange completes in full, and you personally hold a note that pays you principal and interest over time. Because you funded it with outside money, the payments you receive on principal are generally a return of your own cash rather than deferred gain.

Option two is to let the intermediary sell the note, perhaps for 440,000 dollars. The intermediary now has 1.94 million. You either add 60,000 dollars or buy slightly less property. The 60,000 dollar discount is a real economic cost of the arrangement.

Option three is to leave the note outside the exchange. You buy 1.5 million of replacement property, defer the gain on that portion, and report the note as installment sale income over the years it is paid. Tax is paid gradually rather than all at once.

Each route produces a different combination of cash flow, risk and tax, which is why the choice should be made before closing.

What to do first

If a buyer raises seller financing, involve your Qualified Intermediary and CPA before you agree to terms. Decide whether you want the note inside or outside the exchange, and how much outside cash you have to replace it. Draft the note and the exchange documents together, not separately.

Nothing here is tax, legal or investment advice. Seller financing structures are technical and fact specific. Confirm your plan with your CPA, attorney and Qualified Intermediary before acting.