IRS Ruling Gives Guidance on Contract Notes for a 1031

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In today’s economic environment, an increasingly common question we get is how to structure a 1031 exchange for the seller of a property when the buyer wants the seller to carry back a contract in connection with the sale. We started advising our clients on this very issue over five years ago—this year the IRS said we were right!

Say you are selling your property, which is free and clear, for $200,000. The buyer offers to pay $50,000 at closing and wants you to carry a contract for the balance of $150,000. You have a $75,000 gain on this transaction and would prefer to do a 1031 exchange and want to know the procedures.

“Boot” is what the IRS calls cash or property that you take out of an exchange, and Section 1031 says such boot is taxable up to the lesser of the amount of the boot taken or the gain on the transaction. The contract note is considered boot of which $75,000 of it is taxable. (The tax is due when you receive the cash). Since all of your built-in gain attaches to the note, there is no gain to be deferred through a 1031 exchange.

In order to defer the gain on your sale you need to have the note paid into the exchange. This means that the note will be between your buyer and your qualified intermediary. At closing your qualified intermediary will receive the $50,000 cash and the $150,000 note.

Now that your qualified intermediary has the note you must find a way to make it useable in the purchase of your replacement (call it the “new”) property. You really have two options: either transfer it to the seller of your new property as part of the purchase, or convert it to cash.

As a practical matter it is almost impossible to find a seller who will take the note because it will be immediately taxable to them when they receive it even though they won’t receive any cash until your buyer makes their payments.

That leaves you with the second option of converting the note to cash before you can close on the purchase of your new property. You can attempt to sell it, but because it is not “seasoned” the buyer of the note will want a major discount. The best solution is for you to buy the note from the qualified intermediary, and this is in fact what always happens to the notes we hold. Although we’ve been doing it this way for years, the IRS recently blessed this process when it issued Private Letter Ruling 200241016.

Assuming that you buy the note and pay the qualified intermediary $150,000, your 1031 exchange account has now been increased to $200,000 cash and you can proceed to the closing of your new property and complete your 1031 tax-deferred exchange.

The ramifications are that you now hold the note in your name, and your tax basis in it is $150,000 (the amount you bought it for). This means that as you receive future payments on the note from the buyer of your old property the principal part of the payments are tax free (as a return of basis) and you only pay tax on the interest portion.

Clients frequently ask me if they can buy the note for less than the face value. While the answer is yes, you really don’t want to because it reduces the cash in your exchange account (which means you need to bring more money to the closing of your new property anyway), and it means that part of each payment you receive from your buyer is taxable.

What happens if you don’t have access to the cash necessary to buy the note from the qualified intermediary? Either don’t accept anything less than a cash offer or take the buyer to your banker and see if they will make the buyer a loan for the $150,000 if you guarantee it.

What happens if the note goes to the qualified intermediary and you are not able to convert it to cash before the end of the 180 days? The qualified intermediary will deliver the note to you on the 181st day and you will be in the same position that you would have been in had the note not gone into the exchange in the first place (i.e., a portion of each payment will be taxable to you as you receive it).

Another question that comes up frequently is the possibility of doing a 1031 exchange on the balloon payment from a contract that is several years old. The answer is no. In order to avoid tax on any of the contract payments you must have the contract go into the exchange in the first place and you must also convert it to cash during the 180-replacement period and before the purchase of the new property.

My company currently has a brand new one-hour course approved by the State of Colorado for CE credit on Handling Owner Carry Notes & Other Taxable Items in a 1031 Exchange. If you would like The Experts to teach this course to your office staff for free, please call us at 303-694-0204, or visit our website at to schedule a class or for more information.

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