Seller Financing a deal but they want to 1031 Exchange with another property

[Josh Prentice]

Hi All, I am interested in a property that I do not have enough money for a down payment for but it cash flows nicely. The seller wants to 1031 exchange this property with a different one but I was wondering if seller financing could still work. I know he will need cash to finance his deal but is there an opportunity here for me? Or is there another way I can get this deal done? Or am I out of luck...

[Bill Exeter]

The widespread belief is that seller financing and 1031 Exchanges cannot be used together. This is not true. Seller carry-back financing and 1031 Exchanges are often used in combination with each other. However, using them together is considerably more complex and requires careful planning and organization to ensure a smooth and successful 1031 Exchange transaction.

There are really five (5) options to consider when trying to structure the sale of investment real estate with a seller carry back note and a 1031 Exchange together. 

1.  Lender.  You put out-of-pocket cash into the closing to "fund" the seller carry back note. You are effectively acting as the lender.  The seller carry back note is drafted in your name as lender.

2.  Funding Note Inside 1031 Exchange.  You can raise the cash needed to fund the seller carry back note, but you need some time to do so. The seller carry back note would be drafted in the name of the Qualified Intermediary FBO "you." The sale closes and the Qualified Intermediary now holds the net proceeds (cash plus seller carry back note).  Later, you (preferably an affiliate of the Exchangor) raises the cash and deposits the cash into your 1031 Exchange account (before you need to close on the replacement property). Your affiliate is effectively buying the note out of your 1031 Exchange account so that you have all cash for the purchase of your replacement property.

3.  Sell the Note.  You can't come up with the out-of-pocket cash. The seller carry back note would be drafted in the name of your Qualified Intermediary and then you would arrange to sell the seller carry back note to convert the note to cash so that you can proceed with your replacement property purchase.

4.  Use Note as Consideration.  You can't come up with the out-of-pocket cash. The seller carry back note would be drafted in the name of your Qualified Intermediary. You locate replacement property and assign/endorse the seller carry back note to the seller of the replacement property as part of the payment/consideration for the purchase of the replacement property.

5.  Give Up.  You give up and the seller carry back note is drafted in your name (outside of the 1031 Exchange) and is taxable as an installment note under Section 453 of the Internal Revenue Code.

And, there you go.  So, contrary to what you hear or read, you can combine a seller carry back note with a 1031 Exchange, but it gets complicated.  The best advice when you are planning to do a 1031 Exchange is to avoid seller carry back notes.  They are very beneficial for the buyer while the seller assumes all of the risks.