Land Contract Tax Consequences for Sellers and how to 1031 Exchg

Buying & Selling Real Estate
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Land Contract Tax Consequences for Sellers and how to 1031 Exchg

Brice Hall
New York City, NY · Member since 2013 · 110 posts · 15 votes

Hoping a CPA or another person can provide some insight and definitive answers when it comes to land contracts, and tax consequences when selling real estate on land contract. 

Also, if an asset is held for under a year prior to selling on land contract, will this have different consequences than if the asset is held over a year?

Are there ways in which to structure land contracts to further benefit the seller, when it comes to taxes. e.g. an "installment land contract", a "lease with a purchase options", etc.

Lastly, is it possible, and if so, how would one take advantage of a 1031 exchange if selling an asset through a land contract?

Much appreciated in advance to those who share information and resources, particularly beyond "talk to your CPA". I certainly will do this, but hoping to gather general information that may be enough to decide going with a land contract vs. traditional sale.

Thanks!

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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
8y

You said it @Nicholas Aiola, just like the taxation issue land contracts and 1031 face the same moving targets.  It can be done but you do have to be able to pick that point when "risk of loss" passes.  A sale in a land contract can be determined to have happened before the deed transfers if enough of the benefits and burdens of ownership have passed to the buyer that it is as if they own it.  The 1031 would be deemed to start on that date.  If the contract is tight enough then at signing of the contract a 1031 exchange could be started.

But the big problem is going to be how to get the cash to complete the 1031 exchange.  In order to completely defer all tax on a 1031 exchange you must purchase at least as much as you sell.  A land contract generally doesn't come with a significant down payment so the seller is forced to find funds from some place else to use in their replacement purchase.

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  • Nicholas AiolaBusiness Member
    CPA & Investor · New York, NY · Member since 2017 · 1k+ posts · 1k+ votes
    8y

    @Brice Hall land contracts result in an installment sale for the seller, meaning the tax liability is spread over the repayment period (you're taxed on the receipts in the year you receive them).

    There are different rates for short-term and long-term gains. Generally speaking, if you enter into the land contract within a year of purchasing the property, gains will be taxed at short-term (ordinary) rates, even if the installment period is over one year.

    If the sale occurrs after one year of the purchase, the gains will be taxed at favorable, long-term rates.

    With respect to the 1031 - it is possible to do a 1031 when executing a land contract but it's complicated. There's a lot to consider. For example, when did rights of ownership transfer to the buyer (typically it transfers immediately)?

    Also, if you're including the land contract in your 1031 exchange, it becomes a problem trying acquire sufficient proceeds upfront from the sale to reinvest and complete the exchange.

    I'm going to have to tag @Dave Foster in for backup on the 1031 stuff. 

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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    8y

    You said it @Nicholas Aiola, just like the taxation issue land contracts and 1031 face the same moving targets.  It can be done but you do have to be able to pick that point when "risk of loss" passes.  A sale in a land contract can be determined to have happened before the deed transfers if enough of the benefits and burdens of ownership have passed to the buyer that it is as if they own it.  The 1031 would be deemed to start on that date.  If the contract is tight enough then at signing of the contract a 1031 exchange could be started.

    But the big problem is going to be how to get the cash to complete the 1031 exchange.  In order to completely defer all tax on a 1031 exchange you must purchase at least as much as you sell.  A land contract generally doesn't come with a significant down payment so the seller is forced to find funds from some place else to use in their replacement purchase.

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  • Brice Hall
    OP
    New York City, NY · Member since 2013 · 110 posts · 15 votes
    8y
    @Nicholas Aiola very much appreciate your willingness to share insight, thank you!
    1Reply
  • Brice Hall
    OP
    New York City, NY · Member since 2013 · 110 posts · 15 votes
    8y
    @Dave Foster thanks dave!
    1Reply
  • Alan Francis
    Investor · Oak Lawn, IL · Member since 2015 · 20 posts · 4 votes
    3y

    I'm struggling with this very thing right now. 

    I'm considering selling some property owner financed through an installment. Probably dissimilar to most who do this, I'd prefer to finance 100% of the transaction and offer lending terms that are interest only. 

    I'm attempting to create a scenario where I only receive interest income, and the only way to receive any capital gains would be when the buyer eventually refinances the property and pays off the debt instrument in full. I'm also considering language in the note that requires full principal payment only. No partial payments.

    Part of the idea behind this is so that I can utilize a 1031 exchange at that time. 

    Am I way off base here? Is this possible/right?

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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    3y

    @Alan Francis, In order to do the 1031 there's a couple of things that must happen

    1. Rick of loss (or the burdens and benefits of ownership) have to transfer to the buyer.  And the moment this happens is when the sale is deemed to have occurred - not when the deed transfers.  

    2. Your 1031 also starts at this point.  From that moment (usually the signing of the contract or delivery of first payment) you have 45 days to identify your potential replacement and 180 days to complete your purchase.

    3. Your reinvestment requirements for the 1031 are that you must purchase at least aS much as your net sale and use all of the proceeds within those time frames.  Since you won't have any cash from the sale you will have to use your own cash or cash plus financing or 100% financing for the purchase of your replacement property.

    Since the 1031 has to start with the execution of the contract I don't think you'll be able to generate a lengthy period of interest income before recognizing the capital gain.  And let's bring @Nicholas Aiola back in after 4 years.  Hey Nick, will Alan's payments have to be combination of capital gain, interest and return of basis? 

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  • Alan Francis
    Investor · Oak Lawn, IL · Member since 2015 · 20 posts · 4 votes
    3y

    Hey @Dave Foster I'm so grateful you commented. I was hoping you would. After reading some forums yesterday before posting my question I was kind of expecting a response response from you to read the way it did. 

    However, you mentioned one thing that peaked my interest. In your third comment, you described a situation where I use my own cash to complete the exchange. Coincidentally, I just put another property under contract and plan on entering the transaction from a highly leveraged point only putting a small amount of my own capital into the deal. The real world example I'm working on is below (rough numbers):

    Purchased property #1 5 years ago at 225k selling on owner finance at 400k with 175k net capital gains unrealized.

    Entered contract to buy property #2 at 330k at about 90% leverage. 

    in this example is there a way to protect my gain from the "sale"  by tying it to the new purchase even though the amount of capital gain moving out of the first property is 175k and the capital going in to the new deal is only 33k? Other than that fact, it seems to tick the all boxes for a successful and normal 1031. 

    Assuming you respond that i can execute a 1031 this way I have one last question. I promise ;). I very much appreciate you taking the time to reply. If the sale of property #1 is ultimately unsuccessful for some reason. Say in 3 years the new borrower goes into default and I take back the property. What does that mean for the 1031?

    1Reply
  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    3y

    @Alan Francis, Your sale will net you $0 cash.  Your responsibility to defer all tax is to purchase at least $400K in real estate (using all $0 proceeds).  So it would be perfectly fine for you to buy a replacement property using your own proceeds and a loan.  If you've got the $33K for your down payment it would actually work perfectly.

    The one hiccup for you is that your selling $400K and buying for $330K.  So you would pay tax on the $70K difference.  But would shelter the other $105K of profit in the 1031.  Or you could buy two properties to get to the $400K number.

    Once the 1031 is complete that initial property is no longer yours (even though the deed is still in your name).  So it acts just like owner financing.  The gain has gone into the new property.  And a foreclosure simply gets the property back to you.

    Yep, this dog would hunt.  I'll reach out via pm if we can help you out.

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