Seller financing – Alternatives to avoiding “boot” on carry back

A promissory note received as consideration for the sale of Relinquished Property will be treated as “boot” and may be subject to tax.  If a promissory note is received by the Investor at the closing on the Relinquished Property, the note will be subject to tax but may be reported under the installment method (Internal Revenue Code Section 453).  The installment method allows Investor to defer payment of capital gains tax relating to the Note over the period of time that the note is outstanding.

Once the note is paid to IES, the Investor has four different alternatives for attempting to use the note as part of the tax deferred exchange.

OPTION 1 – INVESTOR PURCHASES NOTE FROM IES FOR CASH

This is the most common and practical alternative.  Essentially, the note is replaced with cash paid by Investor to IES in the full amount of the Note.  IES adds the amount paid for the Note to the Exchange Proceeds being held by IES.  The Exchange Proceeds will be applied towards the acquisition of the Replacement Property.  The Investor will receive the Note from IES.  Investor’s basis in the note will be the face amount paid.  As such, the only tax liability that Investor will have upon receipt of payments under the Note from the buyer of the Relinquished Property will be any amounts attributable to interest charged under the Note.

OPTION 2 – THE PAYER ON THE NOTE PAYS OFF THE NOTE PRIOR TO CLOSING ON THE REPLACEMENT PROPERTY

The note is actually paid off during the 180-day exchange period and prior to Investor’s acquisition of the Replacement Property. This works only on short-term notes due within the 180 day exchange period. The payer under the note pays off the note directly to IES.  This amount is added to the Exchange Proceeds and transferred in connection with Investor’s acquisition of the Replacement Property.

OPTION 3 – SELLING THE ON THE SECONDARY MARKET

Rather than selling the note to Investor as outlined under Option 1 above, IES sells the note to a third party investor. The cash proceeds received from the sale of the note are added to the Exchange Proceeds and utilized by IES for purchasing the Replacement Property. Typically the note will need to be sold at a discount, often anywhere from 15% – 40%. If the Note is discounted, the discounted amount MAY be considered a selling expense.   Usually the discount charged by a third party purchaser will offset any tax savings.  As such, this alternative is rarely utilized.

OPTION 4 – USE THE NOTE TOWARDS THE DOWN PAYMENT ON THE REPLACEMENT PROPERTY

The Seller of the replacement property accepts the note as partial payment towards the purchase price. In this scenario, the Note is assigned to the Seller by IES and delivered to the Seller at closing.  This option is rarely feasible as it is difficult to find a Seller who will accept a third party note as part consideration for the sale of the Replacement Property.  This is largely due to the fact that the Seller will be unable to take installment treatment with respect to the third party note.

FAILURE OF ANY OF THE FOUR OPTIONS

If the Investor elects to have the note payable to IES at closing and then is unsuccessful with any of the four alternatives shown above, IES simply assigns the note back to Investor at completion of the exchange. The Investor retains all the tax benefits of the installment method under Section 453 of the Internal Revenue Code that Investor would have had if the note would have been payable to Investor at the closing on the Relinquished Property.