1031 Exchanges and the Complexities of Seller Financing

With interest rates nearly the highest they’ve been in decades, but property prices still high, sellers and buyers are looking for ways to finance real estate transactions while also availing themselves of IRC § 1031’s non-recognition of taxable gains in like-kind exchanges (“1031 Exchanges”). When considering options such as seller financing in 1031 Exchanges, both the seller and buyer need to be aware of certain potential pitfalls when the seller takes back a note.[1] This stems from a basic principle of IRC § 1031, that a pure exchange of qualifying real property for real property will receive nonrecognition treatment,[2] but that other (non-qualifying) property received in the transaction, commonly referred to as “boot”, does not benefit from such nonrecognition treatment and thus would result in the recognition of gain.[3] A variety of different structures are conceivable, some of which are discussed here.

What Happens When Sellers Take Back a Note?

In most cases, when the seller of the inbound replacement property takes back a note, the debt from the Buyer’s perspective will be treated similarly to a bank loan for purposes of the 1031 Exchange, though boot-netting will still apply.[4]

When the seller of the outgoing property (that is to be exchanged) finances the transaction, complications may arise. In this case, the seller will be treated as receiving boot when the transaction is complete.[5] If the Buyer expects that they will be able to obtain financing from a source other than the seller within the mandated 180-day exchange period,[6] such as a bank, then the Buyer could (1) issue a note that is for a term shorter than the 180-day exchange period; (2) provide the note to the qualified intermediary (“QI”)[7] at the closing; (3) obtain outside financing within the 180 days; and finally (4) pay off the note with the proceeds from the financing, thereby allowing the QI to complete the property exchange. However, this is a very risky transactional structure, not the least of which because of the risk that the hoped-for financing falls through. Alternatively, the QI may sell the Buyer’s note to the party seeking 1031 Exchange treatment for the transaction after the closing but before the 1031 Exchange is completed, although this entails significant risk that the IRS will recharacterize the transaction and treat the note as boot received by the exchanger. If the QI sells the note to a third party, this introduces additional risks and complications around the value of the note.

What Happens With Delaware Statutory Trusts?

In addition to the inherent complications that may arise from seller financing, some investment vehicles which are commonly used in 1031 Exchanges may have their own limitations which may impact plans for such financing. For instance, Delaware Statutory Trusts (“DSTs”), which are commonly used as investment vehicles for real property where multiple investors are desired or needed, have their own tax requirements in order to be eligible for 1031 Exchange treatment — either when winding down a DST and selling its real property assets or when individual investors wish to use a 1031 Exchange to get into or out of a DST. Compliance with IRS Revenue Ruling 2004-86 (which, it is important to note, is a safe harbor rather than a hard rule) requires that the lender on the non-recourse financing for the underlying property is not related to the DST’s sponsor, incoming beneficial owners of the DST (i.e., the investors), the DST’s trustee, or the tenant within the meaning of § 267(b) or § 707(b). Considering that the trustee of the DST is not allowed to have the power to significantly alter the underlying asset(s) of the DST if the DST is to remain eligible for 1031 Exchange treatment, this would prevent the DST from playing the role of the seller-financier. However, a DST could conceivably still benefit from seller financing on its property so long as (1) the property had been purchased; and (2) the seller financing had been secured by the sponsor before the DST’s formation and then both the property and the repayment obligation had been contributed to the DST at the DST’s formation. Note though that compliance with the safe harbor means that the DST could not refinance the seller-financed debt once the DST is formed, absent very particular circumstances, so DST sponsors contemplating such a transaction should not view seller financing as a temporary measure but rather a fixture of the DST which runs the course of its lifecycle.

In all cases, those considering using seller financing in a 1031 Exchange must decide if doing so is worth the additional complications and risks baked into such a transaction.

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[1] It must be remembered that use of the installment method does not change the character of gain received from a note paid out over time, but merely spreads out recognition of the gain over the course of the repayment of the note. See IRC § 453.

[2] IRC § 1031(a)(1).

[3] IRC § 1031(b). Per IRC § 1031(c), a loss may not be recognized in an exchange where boot is received.

[4] See Reg. § 1.1031(b)-1(c); Reg. § 1.1031(d)–2, examples (1) and (2).

[5] IRC § 1031(b).

[6] See IRC § 1031(a)(3).

[7] See Reg. § 1.1031(b)-2 for more on the safe harbor for QIs. See also Reg. § 1.1031(k)-1(g)(4).