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Installment Sales and 1031 Like-Kind Exchanges, Part 1

There are several instances in which 1031 like-kind exchange rules intersect with those for installment sales.  For instance, when an installment sale includes seller financing for which the seller wishes to complete a 1031 exchange but will be receiving some or all of the buyer’s installment payments beyond the 180 day window for concluding the exchange.  There are other situations as well in which section 1031 and installment sale rules overlap.  The following is a discussion of how the installment sale rules interrelate with the rules governing 1031 exchanges.

Seller Financing in the Context of a 1031 Exchange

It is not unusual for a taxpayer to finance the buyer in whole or in part.  Such transactions may or may not involve the seller's intent to complete a 1031 exchange.  The structure of the seller’s financing can take the form of a note and mortgage/deed of trust from the buyer or under Articles of Agreement for Deed.  The specific form should not impact the seller’s options in structuring an exchange as part of the transaction. 

Under an installment sale using a note and mortgage/deed of trust, the question frequently arises whether a taxpayer can structure an exchange when the balloon payment becomes due, rather than at the time the parties enter into the installment sale.  Similar questions are raised with Articles of Agreement for Deed - can the exchange be done at the time of the balloon payment when the buyer is receiving the deed? It cannot, since, for tax and legal purposes, the point of transfer of ownership occurs when the parties enter into the note and mortgage or an Articles of Agreement for Deed rather than when the balloon payment is made or when the deed is issued.

Taxpayer Receiving Cash and a Note

It's very common for the taxpayer/seller to receive money down from the buyer and to carry a note for the additional sum due.  At times, this arrangement is entered into because the parties wish to close, but the buyer’s conventional financing is taking more time than expected.  In this instance, the note should be made payable to the qualified intermediary (the exchange company).  To the extent that the buyer can procure the financing from the institutional lender before the taxpayer closes on the replacement property, the note may simply be substituted for cash from the buyer’s loan. 

It is more likely that the taxpayer’s 180 day exchange period will fall prior to the receipt of funds into the exchange account.  In this case, a solution is for the seller to “buy” his own note from his exchange account with fresh cash.  Essentially, the taxpayer advances personal funds into the replacement property while not receiving the equivalent amount of cash from the buyer at that time. These funds can be cash that the taxpayer already has available, or it can be from a loan that the taxpayer takes out to buy the note.  The benefit to the note buyout is that the future principal payments received by the taxpayer over time will be fully tax deferred. 

In the example above, care should be taken as to when the note (or installment agreement) should be turned over to the taxpayer. There is a natural tendency to pass the cash and note simultaneously. After all, the client is putting into the exchange account the exact same value that he is taking out.  However, because the regulations prohibit the taxpayer from the “right to receive money or other property pursuant to the security or guaranty arrangement,” it is probably better to receive the cash into the account sometime prior to the purchase of the replacement property, while assigning the note to the seller after all the replacement property has been acquired.  Some qualified intermediaries will have a form that they will sign acknowledging the substitution of cash for the note with a promise to distribute the note upon the closing of the exchange account.

Conclusion

There are various scenarios in which an installment sale can impact tax deferral.  In some cases deferral can be attained by the taxpayer’s substitution of cash into an exchange account for an installment note or a sale under articles of agreement for deed. In our next post, we examine more complex instances involving installment sales and 1031 exchanges.


 

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