How Owner Carry Notes Impact a 1031 Exchange

Even though mortgage money is plentiful and interest rates are low, we still get a lot of questions about "owner carry" notes and how they impact a tax-deferred or like-kind exchange. Whether you call it seller financing or contract for deed or purchase money mortgage, what we are talking about is the amount of financing that 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, or 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 are uncertain how the $20,000 note would affect it.

I'll explain how to make this tax free in a moment, but first let me give you some back ground. Anything that you receive in connection with a 1031 exchange is called "boot" by the IRS and means that it is taxable to you. The good news about boot in this situation is that 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 bad news with this scenario 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. Let me explain, if you've taken $15,000 of depreciation on your Old Property, the $20,000 boot will be taxed first as $15,000 recapture tax (usually at 25%) and the balance of $5,000 at capital gains rates (usually at 15%) for Federal income tax purposes. In addition, you will pay state tax on the entire $20,000. In other words, in this example, you would pay $4,500 of Federal income tax ($3,750 of recaptured depreciation and $750 capital gains tax) and $1,000 of state income tax (if the state rate was 5%), for a total of $5,500, or effectively 27.5%.

...the good news is you don't pay tax until you receive the boot -- meaning you can pay as you go.

If you didn't want the note to be part of the exchange, it would read something like: "Bob Buyer promises to pay Sam Seller, $20,000," and it would be taxable. So, how do you get around this in a 1031 exchange? The answer is to put the owner carry note into the exchange. To make the owner-carry note a part of the exchange you must structure it carefully.

The first step is to have the note read: "Bob Buyer promises to pay The 1031 Exchange Experts, as Qualified Intermediary, $20,000." This makes it not taxable to you since the note would actually come to us, the Qualified Intermediary (QI) for the exchange. At this stage of the exchange we, the QI, 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, you, or one of your relatives, will buy the note from us. This has to be done prior to the purchase of your 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.

Sam Seller, because he bought the note from us for $20,000, has a basis in the note of that amount. As the owner of the note (because he bought it from us, the QI), the payments will now come to him. The principal he receives on the note is tax free because it is a "return of basis." The interest received is always taxable.