1031 for installment contract?

Question

I am preparing a contract to sell a property right now and we are carrying the note. The buyer will more than likely do the owner financing for a couple of years then either pay off or finance into a traditional loan. My question is - can I still use that lump sum payment at that point down the line to do a 1031 exchange or does it have to be at the time of the purchase transaction? Secondary question to that - this is a commercial property but I mostly buy residential - if I was able to do the exchange could I buy a residential property since it's still going to be "investment" property or would it have to be another commercial property to satisfy the like kind requirement?

Dave Foster · Answer

@Adam Odom, sorry it's 180 days period.  If you don't put the note in the exchange it's taxable the second you accept it.  If you put it in the exchange but don't replace it before the 180 days then it is taxable at day 180 (the advantage to this  is that you would recognize the gain in 2018 rather than 2017 so tax wouldn't be due till 2019).  But if you exchange it during the 180 days then it is not taxable and you can complete a full 1031 exchange.

Adam Odom · Answer

@Dave Foster Ok I think I'll just have to take it as is for now. Thanks for the help - very good information! I'll connect with you in the future because while we're mostly in the "buying" phase we did sell one rental already this year but just used the proceeds to pay off two other loans. I want to start exchanging in the future on others we sell.

Adam Odom · Answer

@Dave Foster Great! I figured there was some sort of work around. So basically holding the note in the exchange would be sufficient? I know you mentioned 180 days but that's only if I didn't have the note in the exchange too correct? Would the payments he makes monthly until the lump sum have to go into the exchange as well? I hope that makes sense.

Dave Foster · Answer

@Adam Odom - Good news.  Any kind of investment property can be exchanged for any other kind of investment property.  So going from commercial to residential is perfectly fine.

More good news - Yes there is a way to use a 1031 exchange with an installment sale.  You don't have to have the lump sum at closing.

The bad news - You do have to have the lump sum before the end of your 180 day exchange period which starts with the date of the closing of your sale.

You could sell the note on the secondary market but an unseasoned note is going to take a huge hair cut.

The way you can make it work is that the note as well as the down payment go into your exchange account.  Then sometime before you have to close your purchases you get cash from somewhere (it could be reserves on hand, money borrowed from anywhere friend or stranger, equity from another property, or even the actual pay off from your purchaser) it doesn't matter from where.  And you replace the note in your exchange acct with that cash.

At that point in time your exchange account is now all cash and you can finish up your exchange.  And outside the exchange is now the note which you "paid" full value for so there is no tax associated with that note other than the interest as it comes in.

Doing it this way you get the full benefit of a 1031 exchange, and tax free cash flow from an owner carry note.