Seller Carry-back Financing In a 1031 Exchange
As a Seller in a 1031 exchange, navigating this current real estate market can leave you feeling like you no longer have control of the deal. With the constant flux of financial interest rates, the Buyer’s purchasing power can differ greatly overnight if they aren’t locked in on preferable rate. Therefore, keeping the deal together may fall apart just on the financing aspect alone. But, what if there was a way to help the Buyer out, that was favorable to you, the Exchanger, and still be able to move forward in your 1031 exchange?
If this sounds familiar, and you are financial capable, then maybe you should consider carrying back a Promissory Note on behalf of the Buyer. Once the terms of the Note have been solidified then the Exchanger has options on whether or not it behooves them to include the Note within the 1031 exchange. Of course, the goal with most real estate investors is to defer any capital gains tax and including the Note inside the exchange allows the Exchanger to do just that. Here’s how it works:
Including the Note Within the 1031 Exchange:
When keeping a Note inside of the exchange, several factors must be met in order for the payments to be tax deferred as well. The first step is to make sure the Exchanger’s 1031 company, i.e. the Qualified Intermediary (“QI”) becomes the Beneficiary of the Note. This means that any payments being made by the Buyer are paid directly to the QI on behalf of the Exchanger and are to be included with any exchange funds the QI received from the close of the sale transaction. This Note is recorded and acts as a lien against the property, typically in the 2nd position as the Buyer’s Loan will be held in 1st.
Now that the Note is included in the 1031 exchange, the Exchanger must either sell, transfer OR pay off the Note within the 180-day exchange timeframe. If the Exchanger decides to sell the Note to a third party outside the exchange, then the monies received from the payoff will be included with the Exchanger’s funds from the close of the sale transaction. Finding the right party who agrees to terms of a Note they didn’t structure or trusting someone they don’t know to continue making payments can be a difficult task. However, the Exchanger may use the Note as a bargaining tool when looking for replacement property. They may offer to transfer the Note to the Seller of the replacement property, in addition to any proceeds received from the exchange. Again, not the most favorable situation as most Sellers want cash, not cash and a Note, but an outside of the box possible solution.
The downside to keeping the Note inside the exchange is when the Exchanger is unable to find a third party to buy the Note or transfer it to the Seller of the replacement property, the Exchanger either has to use their own money to pay off the Note themselves OR the value of the Note becomes Boot and will be subject to capital gains tax.
For many the risk seems too great and therefore consider leaving the Note outside of the exchange.
Excluding the Note From the 1031 Exchange:
If the Exchanger chooses this option then the Note remains between the Exchanger and the Buyer, meaning any payments received go directly to the Exchanger outside of the exchange. The payments will be taxed as income the year they are received. If the Exchanger knows they intend to keep the Note outside of the Exchange, it may make sense for the length of the Note to be longer so the monthly payments are smaller in order to minimize any taxable income.
The downfall to this option would be if/when the Buyer refinances the property and pays off the Note in full. In this scenario, the Exchanger could be hit with significant taxes if they received a large lump sum in that one year where maybe they didn’t have other losses which could offset this gain.
The third option is the most flexible and favorable to the Exchanger only if they are financially capable of going this route and that is to act as a Private Lender to the Buyer.
Exchanger Becomes the Private Lender for the Buyer:
This may be the most favorable option to both the Buyer and the Exchanger. If the Exchanger has the funds readily available, Exchanger may loan the Buyer all the cash to close on the property. Again, the terms of the loan may be favorable to not only the Exchanger but the Buyer as well. Maybe the Buyer can afford a larger purchase price if the interest rate is more favorable than what the large financial institutions offer.
The benefit to the Exchanger is that this private lending structure does NOT adhere to the exchange timelines. This is a private financial loan, not a Promissory Note. The amount of the loan shows on the Buyer’s Settlement Statement as debt owed. On the Exchanger’s side of the Settlement Statement as Seller, it shows funds being received. The funds are held by the QI, typical of any deferred exchange, and released towards Exchanger’s purchase of replacement property or expiration of either the Identification Period or 180-day exchange period.
Since your private loan is recorded against the property, held in 1st position, should the Buyer default, the property is your recourse. Or, if the Buyer chooses to refinance the property, down the road, your lending obligation will be fulfilled and your balance owed will be paid to you in full.
Before you allow a real estate deal to fall apart, know you have options. Having a savvy real estate team (your real estate agent, QI, lender, financial advisor, accountant, attorney, etc.) can make all the difference in having a deal go from good to great.
Southern California Exchange Services excels at helping clients strategize and optimize their real estate investments through 1031 Tax Deferred Exchanges nationwide. We are committed to helping our clients pursue and realize their financial goals and are ready to help you, too. If you have any questions about the 1031 Tax Exchange, or are ready to take the first step, please visit our website or reach out to us at info@sces1031.com We look forward to hearing from you!