By
Gary Gorman, Managing Partner of The 1031 Exchange
Experts, LLC
In
today’s economic environment,
an increasingly common question we get is how to
structure a 1031 exchange for the seller of a property
when the buyer wants the seller to carry back a
contract in connection with the sale. We started
advising our clients on this very issue over five
years ago—this year the IRS said we were right!
Say you are selling your property, which is free
and clear, for $200,000. The buyer offers to pay
$50,000 at closing and wants you to carry a contract
for the balance of $150,000. You have a $75,000
gain on this transaction and would prefer to do
a 1031 exchange and want to know the procedures.
“Boot”
is what the IRS calls cash or property that you
take out of an exchange, and Section 1031 says such
boot is taxable up to the lesser of the amount of
the boot taken or the gain on the transaction. The
contract note is considered boot of which $75,000
of it is taxable. (The tax is due when you receive
the cash). Since all of your built-in gain attaches
to the note, there is no gain to be deferred through
a 1031 exchange.
In order to defer the gain on your sale you need
to have the note paid into the exchange. This means
that the note will be between your buyer and your
qualified intermediary. At closing your qualified
intermediary will receive the $50,000 cash and the
$150,000 note.
Now that your qualified intermediary has the note
you must find a way to make it useable in the purchase
of your replacement (call it the “new”)
property. You really have two options: either transfer
it to the seller of your new property as part of
the purchase, or convert it to cash.
As a practical matter it is almost impossible to
find a seller who will take the note because it
will be immediately taxable to them when they receive
it even though they won’t receive any cash
until your buyer makes their payments.
