Can you 1031 with an owner Carryback 2nd Mortgage

[Eric Fegan]

Does anyone know if you can complete a 1031 exchange if you sell a property but carry back a small second mortgage? For example, if you sell a property for $1mm and receive $900k in cash and carry a second mortgage for the final $100k how does this affect the 1031 and tax consequences? For purposes of the example, assume a 600k adjusted cost basis. Would you exchange out of the $900k portion but pay tax on the final similar to an installment sale.

[Dave Foster]

LOL @Bill B., That's OK I've got broad shoulders (and a thick head as my wife says).  Thanks for the shout out.

@Eric Fegan, What you're suggesting is perfectly doable.  There's a couple of options.  First start with an estimated profit of $400K.  If you do a 1031 exchange the requirements to defer all tax are to purchase at least as much as your net sale (for the example say it's $1 mil) and to use all of the proceeds (this includes cash and cash equivalents like the $100K note).  

1. You can purchase less than what you sell and you can take cash (think of the $100K note as cash) out.  You will pay tax on the $100K but shelter the remaining $300K of profit.  That's one way to handle it.

2. Another way which would still completely defer all tax on all profit is to let the note go into the exchange as a proceed of the sale.  Your exchange account populates with $900K cash and a note for $100K.  Then before you complete your purchase you replace the $100K note with cash of your own from any source.  It could be your own cash reserves or a private loan or equity in another property - doesn't matter.  What does matter is that you trade the note for cash.  So now your exchange acct has $ 1 mil and you can complete the exchange completely tax deferred.

But also, you now own a note outside your exchange that is worth $100K and you "purchased " it for $100K so there is no profit associated with it.  It will come in as payments to you that are tax free except for the interest portion.

3. The third option is to sell the note on the open market prior to the completion of your exchange so the note buyer purchases it out of your exchange acct.  But usually it's unseasoned nature is a non starter and requires too much of a discount.

Either a partial exchange (opt 1) or a note buy out (opt 2) will work for you quite nicely.  The thing I like about #2 is that it completely defers all tax and also gets you tax free cash flow.  A very elegant solution.