Question involving Capital Gains, 1031 Exchange, Seller Financing

[Kristopher Rodriguez]

Hello to all! Thank you in advance for reviewing my question. My question involves three parts: Capital Gains tax liability, a 1031 exchange, and seller-financing. Here is the scenario:

- Investor purchases a property for $100,000

- Investor sells property for $300,000

- Investor provides seller-financing for $100,000 with interest-only payments for two years, then a final balloon payment

- Investor receives $200,000 NET from the sale

Questions:

1. Is the capital gains tax liability during the year of the sale $100,000 or $200,000?

2. If the tax liability is $100,000 because the additional $100,000 principal has not been received yet, is the additional $100,000 taxed during the year of the balloon payment?

3. Can a 1031 exchange occur only once during this transaction (using the $200,000 the seller NETs on the sale date)? 

4. Can the additional $100,000 principal balloon payment be exchanged when it is received two years later?

5. Does this scenario essentially force the seller to pay capital gains on the $100,000 principal balloon payment in the future, with no opportunity to use the money towards a 1031 exchange?

Thank you!!

[Dave Foster]

@Kristopher Rodriguez,  Owner carry's are a little more complicated than that.  If you sell with an owner carry back the gain is recognized at the moment of sale.  However the tax is not due until receipt of the gain via the installment payments.  Every payment (unless specified as interest only) is a mixture of basis, gain, and interest.  And you are taxed on each as appropriate.

Here's where it fits with the 1031.  A 1031 exchange is the sale of a piece of real estate followed by the purchase of a piece of investment real estate.  If you touch the proceeds from the sale you incur the tax on those proceeds.  When you sell with an owner carrry there are two proceeds from the sale - the cash down payment and the owner carry note.  Both must go into the exchange account if you want to defer the tax on the gain. The only opportunity to defer tax in this situation is at the closing of the first sale and in the following manner:

If you start an exchange with the sale and the cash and note go into the exchange account then you can still defer all tax.  The way you do this is to take cash from the outside (your own reserves, equity from another property a loan from a friend - anywhere).  You trade this cash for the note in the exchange.  Now you have cash only in your exchange account and can finish the 1031 exchange fully tax deferred.

Meanwhile, outside the exchange, you have a not that you "paid" it's face value for.  So the note is now tax free except for the interest that comes in every month.

It's a relatively complicated process.  But if you can line up the cash to exchange for the note it can be very financially beneficial as you totally defer all tax on the sale of your property and end up with tax free income (other than interest) outside the exchange.