If you sell your property under a contract for deed with a percentage down and the balance paid in a balloon in five years, can you do a 1031 exchange?
First of all, a disclaimer: every contract is written differently. In general, when you enter into a contract for deed you’re effectively conveying equitable title to the buyer. You’re giving them possession of the property. Typically, the vendee on a contract has to pay the property taxes, insurance, and more. They’re the owner for tax purposes. Think about who takes the depreciation deductions on the property that was purchased on a contract for deed. The vendee does (generally speaking) because they have the rights to utilize the property.
When you’re a vendor on a contract for deed you’re selling the property with an installment sale. You’re retaining the bare legal title as an enforcement mechanism to compel the vendee to make their required payments. You’re retaining the bare legal title, but you’ve effectively given the vendee equitable title for tax purposes.
So you’ve basically sold the farm when you entered into the contract for deed. Five years from now when you get paid off on the balloon payment you probably cannot do a 1031 exchange when you’re giving the legal title to the buyer.
How do you work around the fact that you’ve conveyed equitable title in this situation? The first option is to not do seller-backed financing because it complicates 1031 exchanges. That’s not a satisfying answer for many, particularly when interest rates are rising.
Here’s another option: let’s say you’re selling a duplex for $500,000, the buyer is giving you $100,000 down at closing and you’re financing $400,000 for five years. One way to fix this problem is to have the vendee bring their $100,000 in and have the vendor bring in $400,000 out of their own pocket. If you bring in your own cash to loan to the buyer, that means amount of funds in the exchange account will be the same as you’d normally get if there wasn’t seller-backed financing. Having the exchangor finance the buyer out of pocket is a great way to fix the problem, but it requires some liquidity.
In the Uptown area there’s a real estate broker that acts as a sort of problem solver for sellers. If you want a clean break from your property – you don’t want to do seller-backed financing and you don’t want to bring capital to the deal, this broker interposes himself and agrees to buy the property with cash and then sells it to the vendee on a contract for deed. This might be another option.
Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.
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