Seller Financing – Just Say “No!” (when you can)
By Felip Holbrook, CES, President, Yakima, WA
Okay, maybe that’s a little strong, but it does draw attention to the fact that in an exchange, “carrying the paper” – providing your buyer with financing for the purchase – can cause some unexpected headaches. This is primarily because the IRS treats seller-financing instruments as “cash” to the exchange. Remember the rule in an exchange is to defer all the tax, the taxpayer must “spend all the cash” proceeds in acquiring replacement property.
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EXAMPLE:
Relinquished property sales price: $250,000
Cash down payment $50,000
Seller financing note $200,000
Total “cash” to the exchange $250,000
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For instance, if the taxpayer “takes” a note from the buyer, or sells using a land sale contract (real estate contract), the amount of “cash” that needs to be spent acquiring replacement property equals the sum of the down payment plus the amount of the note or contract. See the example in the box to the right.
But wait – the taxpayer only really received $50,000 in cash. Can’t he replace the seller-financing note with a mortgage on the replacement property? The answer is unfortunately “no”. In order to defer all the tax in this exchange, the taxpayer would have to purchase at least $250,000 of replacement property, and put down $250,000 in cash.
There are some strategies to address this problem:
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Buy the note/contract out of the exchange. The taxpayer could replace the note or contract with cash from another source – a line of credit, a refinance on a different property, or some other source that is NOT borrowed against the replacement property. This would fully fund the exchange account with “real” cash that can be applied to the purchase of replacement property. The principal payments on the “purchased” note would likely be tax-free (interest will always be reported as ordinary income).
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Sell the note/contract to a third party. This strategy can be expensive, since third-party buyers of notes and contracts usually require a steep discount – a third or more off the face value. Still, it is a viable option.
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Give the note/contract to the Seller of the replacement property as part of the consideration. If the original Buyer is a good credit risk, say a government entity or someone known to be financially stable, this can work very nicely. In most cases, however, this will not be a practical solution.
These strategies can be further complicated by tax rules that may not allow the holder of the note -- if they are not the seller of the property to which the note relates -- to receive install-ment treatment and only pay tax as the principal payments are received.
Those rules are beyond the scope of this article and should be discussed with your tax advisor, or one of our staff. Despite the generally gloomy outlook on seller financing, there are times when seller-financing instruments can work very well:
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A quick payoff. Sometimes a buyer just needs a few weeks or months to get his funds together – perhaps another sale is pending, an inheritance is expected, or a refinance is “in the works”. Under such circumstances, the payoff can be made to the accommodator, who will then have the necessary cash on hand to follow through with the purchase of the replacement property. Of course, this all has to happen subsequent to the sale of the relinquished property and inside the exchange period of 180 days.
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A combination of installment sale and an exchange. A taxpayer may take installment treatment on a sale and thereby defer the tax into the future (tax is paid as principal payments are made). However, any down payment would be taxable in the year received. Some exchangers choose to exchange into replacement property using only the cash from the down payment and excluding the seller-financing instrument from the exchange. This protects the tax deferral on the “up-front cash”, and defers the rest of the tax over the life of the term of the note or contract. This option can be especially attractive if the down payment is large or if deferring the gain into the future would have other tax benefits – such as an expected lower income level in future years.
No matter the chosen scenario, taxpayer and accommodator alike must handle seller financing carefully. And if you have the chance, “just say no” – cashing out may make everyone’s life a whole lot easier!
Felip Holbrook, President of Summit 1031 Exchange in Yakima, Washington is on the CES® Certification Council for the FEA & was one of the first members to pass the Certified Exchange Specialist® exam. Contact Felip at yakima@summit1031.com or 509-576-8081
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