How Owner Carry Notes Impact 1031 Exchanges

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In this current climate of lender uncertainty, we’re getting a lot of questions about “owner carry” notes and how they impact a 1031 exchange. Whether you call it seller financing, contract for deed or purchase money mortgage, what we are talking about is the amount of financing the seller of a property is willing to help the buyer with.

Let’s say that you are selling your investment property for $100,000, and the buyer of your property is able to put up $80,000 in cash (whether from a loan, his own funds or both), but the buyer needs you to carry back the difference of $20,000. You want to do a Section 1031 exchange, but you’re uncertain how the $20,000 note would affect it.

Anything you receive in connection with an exchange is called “boot” by the IRS, which means it is taxable to you. The good news about boot in this situation is you probably don’t have to pay tax on it until you receive it – meaning you pay tax as you go. However, if you are an “accrual basis taxpayer,” you will pay tax when you receive the note, regardless of when you receive the cash.

...The principal you receive on the note is tax-free because it is a “return of basis...

The bad news with having the owner-carry note outside the exchange is that you will pay tax on the whole $20,000 of the note received. Worse, if the property you are selling is depreciable, the depreciation recapture will apply first. For example, if you’ve taken $15,000 of depreciation on your Old Property, the recapture will be taxed first (currently at 25%) and the balance of $5,000 at capital gains rates (currently at 15%) for Federal income tax purposes. In addition, you will pay state tax on the entire $20,000.

When I say that the note is outside of the exchange, I’m talking about a note that reads something like: “Bob Buyer promises to pay Sam Seller, $20,000,” which makes it taxable to you. So, how do you get around this in a 1031 exchange? The answer is to put the note into the exchange—but to do this, you must structure it carefully.

The first step is to have the note read: “Bob Buyer promises to pay 1031 Exchange Experts, LLC, as Qualified Intermediary, $20,000.” This makes it not taxable to you since the note would actually come to us, the Intermediary for your exchange. At this stage of the exchange we, your Intermediary, would be holding the $80,000 cash proceeds (in a separate account of course – because you don’t want your money in an account co-mingled with any other exchange funds) plus the note for $20,000.

To complete the process of making the note tax free, you have to turn the note into cash. Typically, The Exchanger or one of his or her relatives will buy the note from us. This has to be done prior to the purchase of the New Property. After purchasing the note from us, we would now hold a total of $100,000. All of this money has to be spent on the purchase of the new property; any proceeds not reinvested would be taxable.

For your part, because you bought the note from us for $20,000, you have a basis in the note of that amount. As the owner of the note, the payments will now come to you. The principal you receive on the note is tax-free because it is a “return of basis.” The interest received is always taxable.

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