Owner Financed 1031 Exchange Property

1031 EXCHANGE HANDBOOK ...

EXCHANGES OF A MORE ADVANCED NATURE

Owner Carried Financing in 1031 Exchanges

If you carry back a note on your sale property the IRS will treat this note as taxable.  As the payments on the note come to you, the principal portion of the payment is subject to capital gains tax and the interest portion is subject to ordinary income tax.  How can you prevent this note from being taxable?  First, the note should be payable to the EA which puts the note in the exchange.  The note must first be converted to cash before you can buy the new property.  How do you turn the note into cash?  There are three ways.  Number 1 is to get the seller of the new property to agree to take the note as part of the purchase of the new property.  As a practical matter, you almost never see this.  Number 2 is to find someone to buy the note.  Unfortunately, because the note is unseasoned (i.e., is a brand new note) any buyer of that note would demand a large discount.  Number 3 is that you, as the property seller, buy the note from the EA for face value and the EA assigns the note back to you.  Because you bought the note from the EA at face value as you receive the principal payments they are tax free return of basis to you.  You will pay income tax on the interest on the note as you receive it, but the principal payments are tax free.  Meanwhile, in your exchange account the EA is holding the cash that you now can use to purchase the new property.