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With the given state of the real estate and credit market, taxpayers need to consider a 1031 exchange as a viable option for selling property. But what about seller financing? Can that be included in a 1031 exchange? The answer is yes, and there are some important things to consider when structuring seller financing in order to take advantage of a 1031 exchange.
This article will discuss important factors to consider when initiating a 1031 exchange and the role seller financing can play in the process.
What is a 1031 Exchange?
A 1031 exchange, named after Section 1031 of the US Internal Revenue Code, allows investors to defer capital gains taxes on the sale of property by reinvesting the proceeds from the sale into a similar “like-kind” property. In order for an exchange to be successful, the IRS has strict guidelines that must be followed, including timeframes for identifying and purchasing replacement property, as well as using a qualified intermediary to facilitate the exchange.
To understand how seller financing can impact a 1031 exchange, it’s important to discuss notes and the exchange process.
Notes and the 1031 Exchange
When a property is sold, the proceeds from the sale are generally paid out to the seller in one or more of the following ways:
- Installment Note
- Mortgages and Loans
The first two methods – cash and installment note – are relatively straightforward. The seller is paid in full at closing and holds no further interest in the property. The third method, which consists of mortgages and loans, can be more complicated.
In this case, the seller may still hold an interest in the property after it’s been sold by taking out a mortgage or loan against the property. This can be beneficial for the seller because it allows them to continue receiving payments on the property after it’s been sold. It also allows the seller to remain involved in the property in the event of a default by the buyer.
When structuring a 1031 exchange, it’s important to consider what type of note will be used to purchase the replacement property.
Structuring Seller Financing for a 1031 Exchange
If the seller intends to finance the buyer’s purchase of the property, it’s important to structure the financing in such a way that it meets the requirements of a 1031 exchange.
The first step is to ensure that the terms of the financing are reasonable. The interest rate must be at or below the prevailing market rates, and the loan must be amortized over a period of time that is equal to or greater than the holding period of the property being sold.
Another important factor to consider is how the payments will be made. If the buyer makes their payments directly to the seller, this is considered a “non-recourse” loan and is not eligible for a 1031 exchange. However, if the payments are made to a third party, such as a qualified intermediary, the loan is considered “recourse” and can be used in a 1031 exchange.
The final factor to consider is the timing of the loan. The loan must be made on the date of closing of the sale of the property being exchanged.
By structuring the seller financing correctly, taxpayers can take advantage of a 1031 exchange and defer their capital gains taxes.
Buyer’s Note Used to Purchase Replacement Property
In a 1031 exchange, the buyer’s note can be used to purchase the replacement property. This is because the note is considered to be part of the exchange and not part of the sale.
The key here is that the buyer’s note must be in place before the sale of the relinquished property. If the buyer’s note is not in place before the sale, then it will be considered post-closing financing and will not be eligible for a 1031 exchange.
Additionally, the buyer’s note must be secured by either a deed of trust or a mortgage on the property. The reason for this is that the IRS considers unsecured notes to be personal property, which is not eligible for a 1031 exchange.
The benefits of using the buyer’s note to purchase the replacement property include:
- The seller can receive payments on the note over time, which can help them with their cash flow situation.
- The seller retains an interest in the property in the event of a default by the buyer.
- The replacement property is purchased with immediate use of the proceeds from the sale of the relinquished property, which can speed up the process.
Note Buyout by Taxpayer Prior to Replacement Property Purchase
In some cases, it may be advantageous for the taxpayer to buy out the note from the seller prior to purchasing the replacement property. This can be done for a variety of reasons, such as if the replacement property is not yet available or if the taxpayer wants to use the proceeds from the sale of the relinquished property to purchase other assets.
When the taxpayer buys out the note, they are essentially paying the seller in cash for the outstanding balance on the note. This can be done through a third-party lender or directly from the taxpayer’s own funds.
If the taxpayer decides to buy out the note, they must do so within 180 days of selling the relinquished property. The reason for this is that the IRS considers anything beyond 180 days to be post-closing financing, which is not eligible for a 1031 exchange.
The benefits of buying out the note include:
– The taxpayer can use the proceeds from the sale of the relinquished property to purchase other assets.
– The taxpayer can avoid having to wait for the replacement property to become available.
– The taxpayer can control when the funds from the sale of the relinquished property are used.
Seller Financing and 1031 Exchange: Learn the Facts
When it comes to seller financing and 1031 exchange, there are a few important things to keep in mind. First, the buyer’s note must be in place before the sale of the relinquished property. Additionally, the note must be secured by either a deed of trust or mortgage on the property. And finally, if the taxpayer decides to buy out the note, they must do so within 180 days of selling the relinquished property. By following these guidelines, you can ensure that your 1031 exchange goes smoothly and that you maximize the benefits of using seller financing.
Reach out to our team of 1031 experts today to learn more about how to structure your exchange. We’ll help you find the right property and walk you through the process step by step. Give us a call to get started.