How Selling Your Property on a Contract Impacts Your 1031 Exchange

Financing the purchase of real estate is tough right now. Lenders are very picky and only a few buyers have come through the last few years without a ding or two to their credit ratings. As a result, it’s not uncommon for buyers to ask sellers to help with the financing of the purchase of the property. 

Whether you call it seller financing, an owner carry or a contract for deed, the facts are the same: the buyer puts up some cash, perhaps gets some financing for part of the balance, and wants you to help make up the difference in the purchase price. Let me give you an example: Bob Buyer would like to buy your property for $100,000. He has a loan commitment for $50,000 and he has $30,000 cash for a total of $80,000, but that leaves him $20,000 short of the funds he needs to buy your property, so he asks if you’ll carry a contract for that amount. If you want to do a 1031 exchange, you need to know that if you accept the contract, it will be taxable to you. This is what the IRS calls boot.

If you don’t mind paying tax on this money, there are a couple of things you need to know. First, the principal will typically be taxed as you receive the proceeds--at the then current tax rate--and taxes are expected to rise starting in January, 2013. (And no, if the terms of your contract call for interest-only payments for, say, five years, you can’t do an exchange on the balloon payment when you receive it five years from now.) 

What can you do to make this situation tax free?
Assuming you or a family member have an extra $20,000 laying around, there are two ways to make the owner carry tax-free. The easiest way is for you to act as the lender at the time of the sale. At the closing the bank will put up $50,000 secured by a first mortgage. You will put up $20,000 secured by a second mortgage and your buyer will put up their $30,000 to complete the purchase. This means that $100,000 will go to your intermediary and be used to purchase your replacement property, resulting in a complete deferral of the gain on your sale. 

If you don’t have cash immediately available at the time of the sale, but you expect to have it before you purchase your replacement property, an alternative method would be to put the owner carry contract into your exchange. This is done by having the contract made payable to your intermediary (Bob Buyer promises to pay 1031 Qualified Intermediary . . . ). This means that just before the closing your intermediary will be holding cash and a note payable to them for $20,000. But you’re not done yet. 

For you to defer the tax on the sale, you have to turn the note into cash before you purchase the new property. Typically this is done by you or a family member buying the note from the intermediary prior to the purchase of the new property. 

In summary, the key to completing your 1031 exchange when a buyer asks you to carry a contract for part of the purchase of your property is whether or not you have available cash (equal to the owner carry) to put into the deal, and whether or not you want to do so.