Seller Financing will impact your 1031 exchange

Although mortgage rates are low right now, it’s hard for most people to get the type of financing they want when they buy a property. It seems the banks still don’t want to part with their money. The end result may be that you have a serious buyer who’s made you an agreeable offer, but who’s having trouble connecting all the dots on the mortgage. He may ask for your help with seller financing.

Whether you call it seller financing, or contract for deed, or purchase money mortgage, what I’m talking about here is the amount of financing that you, the seller of a property, are willing to help the buyer with. Let’s say you and your buyer have agreed on a price of $100,000 for your property. The buyer has $20,000 to put down and was hoping for an 80% mortgage of $80,000. But the most this bank will loan for the purchase is $70,000, leaving your buyer $10,000 short of making this deal work. He asks you if you’d be willing to make up the difference and carry seller financing of $10,000. You don’t want to lose this buyer, so you agree. Then you call me to see how this will impact your 1031 exchange.

The bad news is that without proper structuring, the owner carry note of $10,000 will be taxable to you. So if the note reads: "Bob Buyer promises to pay Suzie Seller. . .", Suzie’s going to pay tax on the note. Like most taxpayers, she’ll pay tax as she receives the principal payments, so the tax will be spread out over the life of the note, at whatever tax rate is in effect when she receives each payment. The interest portion of each payment is, of course, always taxable.

But Suzie can make the note part of her exchange and defer the tax into the future by adding cash to the deal. There are two ways to do this:

1) The easiest way is for her to loan the cash to the buyer at the time of the purchase. In other words, she acts as a separate bank and loans $10,000 to the buyer at the closing of the sale in exchange for a note and a second mortgage or trust deed on the property from the buyer. By adding $10,000 cash to the deal, she avoids having to pay tax on the note. In this case, there’s $100,000 of purchase proceeds at the time of the sale. As Suzie’s qualified intermediary, the $100,000 comes to us to hold and use for the purchase of her replacement property.

2) The second way Suzie can avoid paying tax on the note is for the owner carry note to be payable to her 1031 exchange qualified intermediary. In this case the note would read "Bob Buyer promises to pay the qualified intermediary. . . . " After the sale, we receive the $90,000 of cash proceeds and the note for $10,000 payable to us, and we hold both in Suzie's exchange account. To defer the gain on the note, Suzie must turn it into cash before the purchase of her replacement property. Typically she, or a family member, buys the note from her exchange account prior to the purchase. Then future principal payments received by the note buyer are tax-free because they represent a return of their investment.

So the bottom line here is this: if your buyer wants you to carry a contract on a property you intended to do a 1031 exchange on, make sure that you have enough extra cash to cover the amount of the note, or else be prepared to pay tax on it.