In a sale of real estate, it’s common for the seller, the taxpayer in a 1031 exchange, to receive money down from the buyer in the sale and to carry a note for the additional sum due. The taxpayer facilitates financing for the buyer in this way to make the transaction happen. Sometimes this arrangement is entered into because both parties wish to close, but the buyer’s conventional financing is taking more time than expected. If the buyer can procure the financing from the institutional lender before the taxpayer closes on their replacement property, the note may simply be substituted for cash from the buyer’s loan. Regardless of the circumstance for seller financing, without further steps, the taxpayer’s use of the value of the note toward the purchase of the replacement property will be taxable.
In a non-exchange context there is no problem in the taxpayer carrying back a note from the buyer. However, under the exchange regulations, the actual or constructive receipt of the note would run afoul of qualified intermediary.
The taxpayer and qualified intermediary should also be careful in timing when the note is assigned to the taxpayer. There is a natural tendency to pass the note simultaneously upon receipt by the qualified intermediary of the equivalent amount of cash. After all, the client is putting into the exchange account the exact same value that is being taken out. However, because the regulations prohibit the taxpayer from the “right to receive money or other property” during the pendency of the exchange transaction, it is probably a safer practice to to assign the note to the seller simultaneously with the acquisition of the replacement property or after the replacement property has been acquired. Some qualified intermediaries will provide a form 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.
For more information about 1031 exchanges, contact Accruit by calling (800) 237-1031 or emailing info@accruit.com today!