Can Seller Financing Jeopardize my 1031 Exchange?

seller financing in a 1031 exchange

In a 1031 you need to move your equity to your replacement property to defer all of the gain. If you use some of the proceeds to loan back to the buyer through a seller-backed note or a contract for deed, your equity is not available to you to redeploy into the replacement property.

Cash on the Barrelhead

The first thing I tell people is if you want a simple 1031 exchange, ask for cash on the barrelhead. Tell the seller not to be the bank. Instead, let the buyer go out and get their own financing. That’s fine sometimes, but other times the seller has to give the buyer some type of incentive in order to buy the property and has to engage in seller backed financing.

An easy way to fix that problem is to come to the closing table with a sufficient amount of money to loan directly to the buyer. If you do this that means all of your net proceeds are available to be sent to your 1031 escrow account (because you are adding in the cash to loan to the buyer out-of-pocket).

Have the Note Favor the QI

Another possibility is to loan the money to the buyer but have the note (or other debt instrument) run in favor of the qualified intermediary. That way your QI gets the cash and non-cash proceeds. But what do you do about the non-cash proceeds? We need to at some point sell that note so the QI has all-cash in their exchange account and can use that to apply it to the purchase of the replacement property.

So at some point in the process you’re going to probably have to buy that note from the QI. One way to do that is take out a temporary unsecured loan from a bank, put the money into the QI account, close on the replacement property, and in a post-exchange transaction, you can go back to your banker and increase the indebtedness on the replacement property (to pay back the unsecured loan). But that has to be done after the exchange is over in a separate post-exchange transaction.

  • 1031 Hotline: If you have questions about seller financing, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

 

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