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Exchange with Seller Financing

In most cases, it is preferable for the seller (Exchanger) to receive all cash for the sale of the Relinquished Property. However, many real estate sale transactions require the seller to “carry back” a part of the purchase price as financing to assist the buyer in purchasing the property.

Depending on the sales price, adjusted basis, down payment, and amount of note from the Buyer, the Exchanger may elect to do one of the following upon the advice of their tax or legal counsel:

Carry the Note Back with No Exchange (Taxable): Treat the transaction as a pure sale and recognize gain from the cash received above basis, if any, in the year of the sale and treat buyer’s promissory note as an installment sale (IRC §453) and pay any capital gain taxes on the principal payments on the note when these payments are received by the Exchanger, or

Fund Cash as a Lender (Can be Fully Tax Deferred): Provide the funds required for the seller financing from the Exchanger’s own funds at the closing of the relinquished property, thereby acting as a “third-party lender” for the buyer; or

Have a Qualified Intermediary Take the Note into the Exchange (Can be Fully Tax Deferred): Include the seller-financing note as part of the exchange by naming the Qualified Intermediary as the payee of the note and beneficiary of any trust deed or mortgage at the close of the relinquished property. The value of the note must be converted to “down-payment equity” to be used by the Qualified Intermediary for the purchase of the Replacement Property.

Then the Qualified Intermediary Will:

1) Assign the Note to the Replacement Property Seller (Fully Tax Deferred): Although this results in a complete deferral of gain into the Replacement Property for the Exchanger, the seller of the Replacement Property does not get installment sale treatment on the receipt of the note; or

2) Sell the Note to a Third Party (Can be Fully Tax Deferred): Then use the cash to purchase the Replacement Property. The Exchanger must consider whether a discount charged by the buyer of the note, if any, exceeds or is offset by the capital gain tax that would have been paid under the normal installment sale rules. Note: Sometimes the Lender for the Replacement Property will be willing to purchase the note at no discount since they receive the Relinquished Property as collateral; or

3) Sell the Note to the Exchanger or Friendly” Party (Can be Fully Tax Deferred): Then use the cash to purchase the Replacement Property; resulting in deferral of gain into the Replacement Property. While there is no legal authority as to whether the Exchanger can successfully use this option to defer the note proceeds into the Replacement Property, the approach is reasonable and if done properly should result in favorable treatment. However, the Exchanger should only use this method upon the advice of their tax or legal counsel. Also, the Exchanger or the friendly party should not purchase the note at a discount; or

4) Assign the Note to the Exchanger (Taxable): If the note cannot be converted to down-payment equity, then the note will be reassigned to the exchanger at the termination of the exchange. The exchanger will receive the same installment sale treatment under IRC 453 as if the exchanger had not attempted to defer the note through the exchange. Also, the date for the commencement of the installment sale treatment is the day the note is reassigned to the exchanger from the Qualified Intermediary and not the date of the sale of the relinquished property.