Seller financing and 1031

[Jennifer Dean]

Anyone familiar with seller financing and if you can use down payments you get for a 1031? Or would you be taxed on the gains?

[Dave Foster]

@Jennifer Dean, It is possible to combine owner financing, and down payments in a 1031 exchange.  The proceeds from the sale must be used to purchase the new property.  Those proceeds are 1. The down payment, and 2. the note for the owner carry financing.  The key is that those two things must go into the exchange account.  Then, during the exchange, the note is replaced by cash from another source.  Once the note has been replaced with cash then the down payment and cash can be used to complete the purchase of the replacement property for the 1031.

If the client can muster the cash to replace the note then a couple of good things happen.

1. They can complete a full 1031 exchange and defer all tax on the gain.

2. They have a note that they paid full par value for so the principle return is tax free (all of the gain from that was deferred in the 1031) only taxable portion of this note is the interest that comes in.  So they have some very nice low tax cash flow.

On the other hand, if your question is can a client go forward with a 1031 using only the down payments, it is highly doubtful that there would be any tax savings.  Again, the valuation rules are that you must use all of the proceeds from the sale in the purchase. By taking the note outside the exchange and accepting it, the note becomes taxable boot and is offset against the gain in the sale until the full amount of gain has been recognized.

Example - sell a property for 100K that you had purchased for 50K.  Sell it for 20K down and a note for 80K. If you want to do the exchange both the 80K note and the 20K cash go into the exchange account.  prior to the end of the exchange the client accesses cash from anywhere (loan, savings, friends, etc) and replaces the note for the cash.  Now the exchange account has 100K in it so the exchange can fully continue.  And outside the exchange the client has a note for 80k which they "paid" 80K for so there is not taxable gain on the principle.

If this same client only wanted to use the 20K cash in the 1031 then the 80K note would be viewed by the IRS as taking 80K in boot.  Since the total gain was only 50K taking 80K in boot negates any benefit  to the 1031.

These can be tricky and quite often it's best to go over a clients specific situation to see if it has merit for them.