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Seller Financing and 1031 Exchanges
Proper Structuring
1. Engage a Qualified Intermediary (QI) before closing. The QI facilitates the exchange and ensures IRS compliance.
Make the note payable to the QI
The buyer’s carry‑back note is drafted in the QI’s name, not the taxpayer’s.
QI holds both note and cash
The QI secures any cash proceeds and the seller note in the exchange account
Taxpayer replaces the note with cash or a loan
You deposit cash equal to the note’s value into the
exchange account, effectively “buying” the note from the QI.
QI now holds full cash proceeds
This cash funds the replacement property purchase within the 180‑day exchange window.
Assignment of the note
After closing on the replacement property, the QI assigns the note back to you. You then receive payments from the buyer under the installment agreement.
Important Considerations
Why replace the note with cash or a loan?
If you sell for $500,000 and $300,000 are cash proceeds while the
remaining $200,000 is a carry‑back note, you
must inject $200,000 of your own cash (or financing) to replace the note in the exchange account. Otherwise, the unreplaced portion is treated as
taxable boot under §1031.
Boot Recognition
If you replace only part of the note’s value with
cash, the unreplaced difference is taxable gain.
Installment Sale Rules (IRC § 453)
You can report buyer payments on the note as
installment income over time while the 1031 portion remains deferred.
Interest Income
Once the note is assigned to you, any interest
received is interest income and taxed
accordingly.
Professional Guidance
Professional Guidance
These transactions are complex and require
coordination with your QI and tax advisor to
protect deferral benefits.
Key Takeaway
Professional Guidance
By replacing the seller‑financed note with cash
in the exchange account, investors can retain full tax deferral under §1031 while continuing to receive installment payments and interest
income from the buyer.
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