In most cases where there will be seller carryback financing, the note is not included in the 1031 exchange. The note is taxable boot, but the tax is paid over time as payments are collected. For example, if you sign a five year note and are paid a portion of the principal balance each year, the tax obligation will also be spread out over that five year period. When the note is not a part of the exchange, it should be payable to the seller and delivered directly to the seller at the time of closing. Only the cash proceeds received from the sale of real property are delivered to the Qualified Intermediary (QI) and used as exchange funds.
Replacing the Note with Cash (Hard Money Loan)
Some sellers elect to lend the money to the buyer of the Relinquished Property up front as a “hard money loan” rather than through seller carryback financing. Using this option, the seller acts as a third party lender and deposits cash in the amount of the loan into escrow. The buyer uses the loan funds to acquire the property, and then escrow delivers those funds to the QI for use in the exchange.
Lets assume that the exchanger sells the Relinquished Property for $100,000. The buyer wishes to pay $20,000 and give a promissory note for the balance of $80,000.
Example: Exchanger has access to additional cash to fund the value of the note as a hard money loan to the buyer. Exchanger funds $80,000 cash to escrow at closing of the relinquished property sale, representing Exchanger’s loan to buyer. Qualified Intermediary receives $100,000 cash proceeds from escrow upon the sale of Relinquished Property. Exchanger receives the buyer’s note (payable to exchanger) and security instrument outside of the exchange. Exchanger’s basis in the note is $80,000; principal payments on the note are nontaxable as return of principal, interest payments are taxable as ordinary income, as received. Qualified Intermediary applies the $100,000 towards Replacement Property, allowing for a completely tax deferred exchange.