Splitting proceeds from a sale in a 1031 exchange?

[Ron Thomas]

Hello all,

So here's a quick run down of the situation I am asking about.  Myself and another investor in the suburbs of Detroit are looking at a 140 unit apartment complex being sold by a larger investor who wants to recycle his resources into a larger deal.  Its on the market for about 4m.  We walked it with the broker's assistant (the broker was out of town for the holidays), looked over the pro-formas, and decided everything looked good enough to write a letter of intent.  A few hundred K in capital investment is needed fairly quickly, and in order to make sure were not short on cash during the reposition, we need a seller carry back of about 10%.  We called the brokers assistant to ask if this was possible, he called someone on the seller's side and returned a response of 'the seller will entertain a 10% carry back'.  'Great!' we thought.  Then, a couple hours later, the actual broker direct emailed my partner and said 'A carry back is not an option here, the seller is doing a 1031 exchange with the sale proceeds'.

So here is what I am looking for advice concerning.  A) Can the seller simply split the 1031 proceeds and maintain his tax advantages on at least the 90% he recycles if not also the 10% he leaves in the property via-us?  B) We have enough funds to close this property on our own but need this extra portion for cap ex after we buy.  Could how we structure his 10% carry back effect his 1031 eligibility?  In other words, instead of him leaving 10% in the property, could we buy it and pay him then, through a PPM or some other legal doc, have him reinvest the cash equivalent of 10% of the sale price back to us to leave his desired tax deferment intact?

This is a deal I would like to close but am not willing to risk being underfunded for.  I think the broker may be viewing the entire transaction as a little to linear.  My partner gets the impression the broker thinks of him as 'amatuer-ish' because were both relatively young and this would be our biggest investment to date.  There is some merit to that notion, were not large investors yet, but why not just walk away with a sale and nice commission check then watch us fall on our face from a distance if this is how the broker feels?  Who knows, maybe we'll succeed and bring a repositioned deal back to him.  We havent replied to the broker with what we plan to do yet.  I would like a sound plan that achieves our funding goal while maintaining the tax benefits of the seller before we reply.  That way, even if were 'ameture-ish', how we conduct ourselves will be 'pro-ish'.  I appreciate any advice.  

[Bill Exeter]

Hi Ron,

A 1031 Exchange can be structured with a 1031 Exchange, but it also significantly complicates the Seller's 1031 Exchange transaction in that he/she needs to acquire replacement property but will not have all cash in the 1031 Exchange to do so.  There may also be other options as well.  

The Seller will first need to decide if he/she wants to defer all of his/her taxable gain.  If so, then the Seller Carry Back Note must be included inside his/her 1031 Exchange.  If not, then the Seller Carry Back Note would be excluded from his/her 1031 Exchange and the note would be taxable under the installment sale rules (Section 453 of the Internal Revenue Code).  I've copied and pasted part of an article that I wrote on this topic below.  "You" refers to the Seller structuring a 1031 Exchange transaction with a Seller Carry Back Note.

Seller Carry Back Note — Inside or Outside the 1031 Exchange

Special planning is required when you intend to complete a 1031 Exchange and carry-back an installment note as part of the 1031 Exchange transaction.

The common misconception is that seller carry-back financing and 1031 Exchanges can not be used together and are mutually exclusive.  This could not be further from the truth.  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 can not 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.

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. 

It is extremely important to 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.  This can create liquidity issues for you during tax time, so be sure to plan accordingly. 

Not including the seller carry-back note within your 1031 Exchange  transaction 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 over the term of the installment note.

It is extremely important to remember that  your depreciation recapture income tax liability is immediately recognized and taxed in the year of the sale and 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.

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. 

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.

Complications with Including the Installment Note in the 1031 Exchange

Structuring and closing the relinquished property sale transaction with the seller carry-back installment note included as part of your 1031 Exchange is the easy part.  It gets more complicated from here on out because your Qualified Intermediary is holding more than just cash in your 1031 Exchange account.  How does your Qualified Intermediary use the seller carry-back installment note to acquire your like-kind replacement property?

There are really three (3) potential solutions:

1. You can use the installment note  as part of the consideration paid for the purchase of your like-kind replacement property.  This solution, however, assumes that a seller of the taxpayer's replacement property would be willing to accept the third-party installment note  as full or partial consideration their property.  It is a possible solution, but not usually a very practical solution.
2. You can convert the installment note into cash by selling it to a third party investor.  This could be a viable option, but in most cases the installment note would have to be sold at a significant discount and would not be a practical solution either.
3. You could  contribute additional personal funds into your own 1031 Exchange account equal to the face value of the installment note (boot paid or contributed) so that sufficient cash funds now exist inside your 1031 Exchange in order to complete the acquisition of your like-kind replacement property.  The note and deed of trust or mortgage would then be endorsed/assigned to you (boot received) after your 1031 Exchange transaction has been completed.  This structure is probably the most practical provided you have the necessary liquidity to fund the strategy.  It results in the boot received being offset by the boot paid and therefore does not generate any income tax consequences.

Including or excluding the seller carry-back installment note within your 1031 Exchange is not an easy business decision.  In most cases the inclusion of a seller carry-back note with a 1031 Exchange will work if there is sufficient pre-exchange planning to ensure the availability of the proper liquidity to fund the transaction.  And, the inclusion of the installment note usually makes sense from an income tax perspective. 

However, you should decide whether you would even want to accept a seller carry-back installment note as part of your 1031 Exchange transaction, or avoid the headaches involved with a seller carry-back installment note and insist on an all cash transaction for the purchase of your relinquished property.

You should always consult with your legal and tax advisors as well as your Qualified Intermediary prior to completing a seller carry-back installment sale as part of your 1031 Exchange transaction.

The Alternative: Act as Lender

If you (the seller) have sufficient funds to do so, you could merely serve as a lender in the transaction as well.  You could "lend" the amount of the intended Seller Carry Back Note by depositing sufficient funds into the transaction to cover it and then take back a second position mortgage or deed of trust.  This way you are using out of pocket (non-1031 Exchange funds) to cover the difference and the Qualified Intermediary will receive 100% of the funds.

Depreciation Recapture Income Tax Issues

The inclusion of the  seller carry-back installment note inside your 1031 Exchange transaction will defer the recognition of your depreciation recapture and capital gain income tax liabilities.

Excluding the seller carry-back installment note from your 1031 Exchange transaction will result in the immediate recognition of your depreciation recapture income tax liabilities in the year in which the sale of the relinquished property closed, and your  capital gain income tax liabilities will be deferred and recognized over the term of the seller carry-back installment note.