Carrying Back a Note in a 1031 Exchange

Carrying Back a Note in a 1031 Exchange

In some situations, a seller may decide to carry back a note for a buyer and still want to execute a 1031 Exchange. This article will examine this situation and provide options to this type of transaction.

Let us set a scenario going forward. John Doe is selling property to Mary Smith. The sales price of the property is $100,000. Ms. Smith is putting $60,000 down and Mr. Doe will carry a note for her in the amount of $40,000.

There are primarily three options when a seller wished to take advantage of the 1031 Exchange and still carry back a note for the buyer:

  1. Seller receives the Note outside of the 1031 Exchange
  2. Note is included in the 1031 Exchange, or
  3. Seller acts as hard money lender at closing.

In Option 1, Mr. Doe will receive the note outside of the exchange. At the closing of the sale, he will put the $60,000 down payment into the 1031 Exchange and he will take the note for the $40,000. In this case, when he received the payoff on the note, he will most likely have a taxable event. This is considered “cash boot” in the transaction. He will pay taxes on the payoff of the note in the year that he receives it. He could not do an exchange on the payoff of the note, though. This is not the sale of property, so it is a non-exchangeable asset.

Under Option 2, the note will be made payable to Security 1st Exchange and at the closing of the sale, the $60,000 cash and the $40,000 note will come to us as Qualified Intermediary. Now, Mr. Doe must liquidate the note within the exchange period. He can do this in a few ways:

  1. Note is paid off by Mrs. Smith (the borrower) within the 180 day exchange period. Then, Mr. Doe has a fully funded exchange and can now use those funds to purchase replacement property.
  2. Mr. Doe could sell the note to a 3rd party who would then pay Security 1st Exchange for the note. The downside to this option is that most note buyers want a discount on the note, so Mr. Doe would have a loss.
  3. Mr. Doe could find a seller who would assume the note. If he were to find a buyer who was selling a property for $100,000, he could pay them the $60,000 cash being held in his exchange account and then also assign the $40,000 as the remainder of the consideration for the property.

There are options in this scenario, but it would take the right situation to make things work.

Finally, Option 3 is probably the easiest to carry out, but requires our seller, Mr. Doe, to come up with cash.

Mr. Doe is the seller on this transaction, but he could also fill the role of a hard money lender. At the closing of his sale, he brings to the closing table $40,000 cash, just like a normal lender would. The buyer brings in their $60,000 deposit, and now the closing agent has $100,000, the full purchase price. There is a note created between seller and buyer for the $40,000 loan, and the $100,000 cash comes to Security 1st Exchange representing the entire purchase price on the transaction. Now, Mr. Doe can complete his exchange and will receive the note payments from Ms. Smith outside of the 1031 Exchange.

As you can see, there are options in transactions where a note is involved, but there are some complications that must be addressed. Coordination with the Qualified Intermediary and a tax or legal representative is highly recommended.

For additional information, please reach out to your tax professional for specific questions or contact the specialists here at Security 1st Exchange for assistance.