During rising mortgage rate environment, you may be requested by real estate buyers to assist them in the acquisition of your relinquished property with the financing. This means they are asking you to carry back an installment note or promissory note, which is often referred to as “Seller Financing,” “Seller Carry Back Financing,” or a “Seller Carry Back Note.”
Seller carry back promissory notes can be a creative sales tool when negotiating and structuring real estate transactions, especially in rising interest rate, and tight credit markets. This kind of financing can also be a very effective income tax planning and/or estate tax planning strategy for you if you do not want to 1031 Exchange into other like-kind replacement properties. Seller Carry Back Note — Inside or Outside the 1031 Exchange
Advance planning is required when you intend to complete a 1031 Exchange and carry-back an installment note as part of the 1031 Exchange transaction.
A common misconception is that seller carry-back financing and 1031 Exchanges cannot be used together and are mutually exclusive, not so! Seller carry-back financing and 1031 Exchanges are often combined in the same transaction. They do, however, require careful advanced planning and structuring to ensure a smooth 1031 Exchange transaction.
You must decide prior to the close of your relinquished property sale transaction whether your capital gain income tax consequences related to the seller carry-back note will be deferred under the installment sale rules pursuant to Section 453 of the Internal Revenue Code or pursuant to a Structured Sale drafted pursuant to Section 453 as well, or will be deferred via a 1031 Exchange pursuant to Section 1031 of the Internal Revenue Code. The installment note and deed of trust or mortgage will be drafted differently depending on which strategy you select. Once the relinquished property sale transaction has closed you cannot change your mind, so it is important to meet with your advisors ahead of time to ensure that you make the correct decision for you prior to the close. Here are two options:
1: Excluding the Note from the 1031 Exchange — Installment Sale Treatment
Should you decide to exclude the seller carry-back note from your 1031 Exchange transaction, the promissory note and the corresponding deed of trust or mortgage would be drafted with you listed as the beneficiary or owner of the promissory note. Your 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 cash portion or net proceeds from the sale transaction would be sent to your Qualified Intermediary at the close of your relinquished property sale transaction and the installment note would be owned and held directly by you and would not be part of your 1031 Exchange.
The installment note and corresponding deed of trust or mortgage would be taxable under the installment sale rules pursuant to Section 453 of the Internal Revenue Code. Your capital gain income tax liabilities are deferred over the term of the installment note and would be recognized and taxed as principal payments from the installment note are received by you.
Do note that your depreciation recapture income tax liabilities are not deferred over the term of the installment note, but are actually recognized and taxed in the year in which the relinquished property sale transaction closes, so be sure to plan accordingly. At the same time, your capital gain income tax liability is only deferred over the term of the installment note.
The entire income tax liability would be immediately recognized when the entire outstanding principal balance of the installment note is paid off and received by you. This can be problematic should the borrower decide to pay off the promissory note early. You may want to discuss including a prepayment penalty in the promissory note with your advisors.
You may want to consider including the seller carry-back note inside of your 1031 Exchange transaction so that the capital gain and depreciation recapture income tax liabilities can still be indefinitely deferred through your 1031 Exchange.
Excluding the Note from the 1031 Exchange — Structured Sale Strategy
You could also decide to exclude the seller financing from your 1031 Exchange, but to include the seller carry back note inside a Structured Sale.
Your 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 being processed through the Structured Sale. The cash portion or net proceeds from the sale transaction would be sent to your Qualified Intermediary at the close of your relinquished property sale transaction. The seller financing would not be part of the 1031 Exchange transaction.
The Structured Sale would be taxable under the installment sale rules pursuant to Section 453 of the Internal Revenue Code. Your capital gain income tax liabilities are deferred over the term of the Structured Sale and would be recognized and taxed as principal payments from the installment note are received by you from the Structured Sale.
It is extremely important to note that your depreciation recapture income tax liabilities may not be deferred over the term of the Structured Sale, but may actually be recognized and taxed in the year in which the relinquished property sale transaction closes. This can create liquidity issues for you during tax time, so be sure to plan accordingly.
Including the seller carry-back note in a Structured Sale can be a great exit strategy when you want to get out of real estate altogether but still want to defer your income tax consequences.
You may want to consider including the seller carry-back note inside of your 1031 Exchange transaction so that the capital gain and depreciation recapture income tax liabilities can still be indefinitely deferred through your 1031 Exchange.
2: Including the Note as Part of the 1031 Exchange — 1031 Exchange Treatment
On the other hand, should you decide to include the seller carry-back installment note as part of your 1031 Exchange transaction, the installment note and corresponding deed of trust or mortgage would be drafted with your Qualified Intermediary listed as the beneficiary or owner under the installment note and corresponding deed of trust or mortgage. Learn how to properly draft the installment note and deed of trust or mortgage for your 1031 Exchange transaction on our web page entitled “Legal Beneficiary Vesting for Seller Carry Back Notes included with in a 1031 Exchange.”
Your entire relinquished property sale transaction will be assigned to your Qualified Intermediary so that at the close of the transaction your Qualified Intermediary will receive all of your net cash proceeds as well as the seller carry-back installment note. Note payments to be made during the time that the note is held by the Qualified Intermediary must be paid to the Qualified Intermediary.
The note and corresponding deed of trust or mortgage under this structure would be tax-deferred under the 1031 Exchange rules pursuant to Section 1031 of the Internal Revenue Code. Your capital gain and depreciation recapture income tax liabilities will be indefinitely deferred as long as you continue to exchange throughout your lifetime. However, you will find that including a seller carry-back installment note in your 1031 Exchange transaction is much more complicated than structuring the transaction as an all cash 1031 Exchange transaction.
Wai-Yew Lam, TREC instructor & Qualified Intermediary
wlam@adelphiretirement.com
wwww.AdelphiRetirement.com