Can you use a 1031 exchange to build a property?

[Aden Brust]

Hey guys! I have a potential deal I'm about to go under contract on, there is just one hiccup. The seller is seller financing me the property with a balloon in 3 years if it appraises for the current purchase price in 3 years. She wants to build her dream home in 3 years and wants to use the proceeds to build it. She says she is worried about having to pay 47k in capital gains in 3 years which is a big chunk that could go towards building the house. The property I would buy is in her LLC but she would like the dream home she's building to be in their personal names, can she use a 1031 exchange at the end of the 3 year balloon when I pay her off and use those proceeds towards a new construction build? If not, are there any other creative ways you can think of where it would defer her capital gains? Theoretically in 3 years could I refi and pull out the money she needs and lend it to her to build the house?

I really would like to stick to seller financing on this deal because the terms she wants are amazing and it really could be a win-win all around if she gets to build her dream home. 

Just brainstorming! I’d love to hear any ideas! Thanks!

[Bill B.]

She can’t do a 1031 in 3 years because…

1) She already sold you the property today, in 3 years she doesn’t own it. 
2) She can’t use a 1031 for a dream home, only for investment properties…

Ps. If the property she is selling you isn’t an investment property obviously she never would have qualified. If it is an investment property she should sell outright today and do a 1031 and save $47k. I doubt she’s making an extra $47k doing seller financing. If it was her primary home she shouldn’t do seller financing and should just sell outright today tax free. 

[Aden Brust]

@Bill B. Okay that makes sense thank you. I just want to make sure I understand correctly, so even though she will be receiving a lump sum in 3 years from the balloon payment (it is an investment property she's selling me, not primary residence), she can't 1031 that because technically when she sold it to me today she became the bank and no longer owns the property, so basically the lump sum paid to her at the end, is the same as a bank making money and therefore taxed as income tax? Or would it still be capital gains tax because it is proceeds from that property? I totally understand if you can't answer this, as these may be questions for my cpa who I am calling tomorrow! Thanks for the response!

[Bill B.]

A portion of Each payment you make to her for the 3 years and at the payment at the end will be split in to different reasons/categories. As interest (taxable as regular income), capital gains (usually taxed at 15%), and basically return of principle (pry called something else but payment against her cost basis.) that’s tax free. Her CPA will have to determine when depreciation recapture @ 25% is due. (Could be the day she sells it to you, could be a portion of the payment. I assume it’s not after last payment or sellers would structure it as the last $1 is due in 100 years. :-))

[Andrew Abeyta]

Quote from @Aden Brust:

@Bill B. Okay that makes sense thank you. I just want to make sure I understand correctly, so even though she will be receiving a lump sum in 3 years from the balloon payment (it is an investment property she's selling me, not primary residence), she can't 1031 that because technically when she sold it to me today she became the bank and no longer owns the property, so basically the lump sum paid to her at the end, is the same as a bank making money and therefore taxed as income tax? Or would it still be capital gains tax because it is proceeds from that property? I totally understand if you can't answer this, as these may be questions for my cpa who I am calling tomorrow! Thanks for the response!

You absolutely can use an installment sale in conjunction with a 1031 exchange... though I’m not sure if this is the answer to the current predicament.. we handle these all the time, especially on straddled year 1031 exchanges.

- REI CPA

[Dave Foster]

@Aden Brust, I don't see a path for her to do what she wants without paying tax on the profits from the sale.

1. She would have to start a 1031 exchange with the sale of the property to you.  That means she only has 180 days from that date to complete the process.  She is recognizing the gain when she sells it to you.  When done as an owner carry note it is still due but only as the cash is received.  That's a non-starter by itself.

2. Her owner financing of you will defer much of the tax.  But only until it is paid off (in 3 years) or until the portion of profit comes in each month as @Bill B. said.

3. If you refinance then her note is. paid off and tax is due anyway.