Seller Financing Down Payment + 1031 Exchange

[Daniel Shuler]

Hi all,

I've been all over these forum posts trying to find this answer and I keep going back and forth on whether it can or can't be done, so decided to reach out to some of you experts here.

I'm trying to figure out if a seller, that is trying to do a 1031 exchange, can seller finance the down payment on their current property that they are wanting to sell? I have no idea how much equity they have on the property.

So say the property is listed at $500K, can you get a DSCR loan for say the 70% first position, and have the seller finance the 30% down payment in second position, all while they're trying to 1031 that property into another another one.

Assuming it *is* possible, what would the benefits be for the seller, tax-wise or what would be the ideal strategy here for both buyer and seller?

I keep thinking there's a key detail I'm overlooking here that doesn't make this possible.

Any and all help would be appreciated.
Thanks!

[Sean Ross]

@Daniel Shuler

It is possible to include owner carry financing as part of a 1031 exchange. It's likely best to jump on the phone with an expert to discuss this, but I'll leave a quick description below:

Owner financing is a tricky issue for tax purposes. The IRS considers it a loan, just like any other, that represents potential interest income to the lender (in this case, you). Seller financing won't have any impact on the potential capital gains that you would face by selling a property, either -- you're still selling a property for the same appreciated amount. It doesn't matter if you also happen to be the lender and the seller.

There are a lot of possible issues with seller financing while doing a 1031. It's possible! But you want to be careful. A direct attempt at seller financing will result in taxes being recognized for the value of the carryback note (making the exchange less efficient). The carryback note is not considered a valid asset to receive in an exchange. For example, if you sell a $500K property with $150K in seller financing...well, the $150K will be excluded from the exchange and capital gains taxes will be recognized as payments are made. Even worse, all of the depreciation recapture taxes allocable to the $150K will be recognized and due in the year of sale.

(There are even some who believe that the seller providing a loan to the buyer will disqualify the exchange entirely, but that's not been our experience.)

The most straightforward solution is to have the seller provide a cash loan to the buyer outside of closing. This way the buyer can come to closing with all of the necessary funds to allow for a normal 1031.

If the seller is not liquid enough to provide a loan, they could attempt to find another financing option for the buyer. If this doesn't work, then the seller can have the carryback note made payable to their 1031 Qualified Intermediary. The Intermediary can then sell the note to any party, including the seller or a seller's family/friends. Any proceeds from the sale of the note can be added to the 1031 exchange account to allow for more tax deferral.

The issues get a little deeper, but the key takeaway is that careful planning is very, very important. A lot of my company's clients are trying to do this in 2024, with mixed results.

Happy to answer any questions you have.