Seller 1031 holding a note

[David Benton]

The seller is doing a 1031 on a property I'm buying. Can he do seller financing on a part of the purchase and still do the 1031 with the cash received? Is the note balance considered boot?

[Dave Foster]

@David Benton, A note can be handled easily in conjunction with a 1031 exchange in a number of ways.  You're absolutely right - if the seller takes possession of the note is is taxable as boot.  However, depending on how much cash is being put down it still might be worth it to the seller to take the note and pay tax but shelter the rest of the gain in the 1031.  

At the worst, by taking the note the seller is going to spread out the tax on gain for the duration of the note.  That's not a small mitigation by itself.

But if the seller wants to defer all tax then they must purchase at least as much as their net sale and use all of the proceeds from the sale in the purchase of the new property.  This sale would consist of two proceeds - the cash and the note.  And since the client cannot have receipt of the proceeds in a 1031 the note and the cash need to go to the QI and be put into the Exchange account.

Once the proceeds are with the QI the seller has some options:

1. Offer the note to the seller of their replacement property as part of the purchase consideration (usually not likely)

2. Sell the note on the open market and have that cash go back into the exchange account (usually requires a steep discount on the price because of seasoning).

3. Replace the note with cash of their own from any source - could be savings a personal loan, equity on another property, or any other source.  (access to that amount of cash is the bugaboo with this strategy).  However, once the note has been replaced with cash the exchanger can now complete their exchange with all cash.  And outside the exchange they now own a note that is tax free except for the interest that comes in every month.

If the seller has access to that kind of cash it can be a very profitable situation to them as they completely tax defer the profit from the sale and at the same time gain a partially tax free income source.