* The seller is looking for a long-term income stream for retirement
* The seller would like to spread the tax exposure of the sale over time
* The property is not currently financeable
* It is necessary to close the sale before financing is available
* The buyer intends to flip the property and only needs short-term financing
It is essential that both the buyer and seller understand the terms of the contract. Both should have their respective legal council's approval before authorizing any note. Along with the opportunities of these arrangements come obstacles. Traditionally a tax-deferred exchange was thought to be one of them.
Using a Tax-Deferred Exchange
In today's economic environment the use of seller financing may be necessary in order to simply sell a property. A common misunderstanding of installment sales is their impact on a tax-deferred exchange. Despite what many investors may think, it IS possible to satisfy an exchange and provide seller financing.
Since a note typically represents equity in a property and a 1031 Exchange requires all equity to be carried forward in order to be completely tax deferred, it is necessary to somehow use the note in the exchange. In order for a note to be used in an exchange, the Exchangor must not have had actual or constructive receipt of the note. The note must be held by the Facilitator at the close of escrow just as any cash must be.
The following are options available under these conditions:
1. As the Exchangor, you can direct a third-party 1031 exchange intermediary to sell the note to a third party such as a bank, pension fund manager or a private investor. The proceeds from the sale of the note are then deposited with the intermediary. You will need to deposit additional cash to offset the amount that was discounted on the note for total tax deferral. If the additional cash is not deposited, you will have tax exposure on the difference between the note's value and the discounted sale price of the note if any.
2. The Exchangor can use the note along with the cash to acquire the replacement property. The Seller of the replacement property now owns the note.
3. The Exchangor can also purchase the note from a third-party. The note has now been converted to cash and the exchange can be completed. The Exchangor now benefits from the interest generated by the note, yet does not have a capital gains tax exposure to the gain the note once represented.
4. If the note is short term and matures inside the 180-day exchange period, it is possible to complete the exchange after the note is paid off.
Understanding the motivation behind the sale and the use of the note often dictates the appropriate tax deferral option to be utilized. A careful review of the choices available and their respective tax consequences is critical. A tax specialist or legal counsel will be able to help you make the right decision given the time and information available. Seller financing in today's world can be just the tool to help you make that next deal.
