Combining Seller Financing and a 1031 Exchange

6 Replies

I am seeking to exit from real estate by way of seller financing.  The properties were originally retail and office, but most recently are apartments, so I assume there is recapture of depreciation (not sure if that is section 1245 or 1250).  In any case, alot in taxes would be owed.  And what I am seeking to accomplish is to get out of real estate.  And I had the following questions:

1) If you seller finance and the buyer defaults and they don't cooperate with you, are you still going to be able to complete the exchange process.

2) To know the buyer is serious I will want a serious down payment.  But I don't even want to receive all of that at once.  Can I set time frame(s) during which the money is received (100K a year, for example) by having a exchange accomodator hold the money,etc.  Or would that violate the 180 day rule?

3) Can I stagger the balloon payments?  Such as having a ballon every year for 100K until it is exhausted.

4) If, when I am entitled to receive the funds, if I instead want to 1031 the balloon into another property, can I do that?

5) What I am trying to do is to gradually receive the funds, but I'm not sure how to accomplish that.

6) I have heard a suggestion to do multiple 1031s and receive a certain amount of cash year, but that would be alot of work since I would have to buy 90% of my current assets, then the next year 80% of my current assets, etc.

7) I don't really trust the TIC and/or DST (Delaware Statutory Trust) type properties, so I tend to think of this as the most likely resolution.

8) Since some of these properties are triplexes, some would be classified as residential.  Although I could combine them so they are all commercial.  In terms of prepayment penalties I have heard some commercial brokerages will do a penalty like 5% 1st year, 4% 2nd year, 3% the 3rd year, 2% the 4th year and 1% the 5th year.  Will that complicate the transaction?

Thanks.  Any suggestion appreciated.

@L S., There's a lot in this post that can be boiled down to a clearer understanding of the 1031 process.  Seller financing can be very advantageous if you're looking to exit and want to mitigate your tax bite.  But you've hit on one thing right away and that is that depreciation recapture happens in the year of the sale.  So from the get go you may find that seller financing is a non starter if your properties are highly depreciated and secondarily appreciated.

The 1031 exchange has a limited shelf life of 180 days.  you cannot have actual or constructive receipt of the proceeds which include the note.  So if you want the note to no be taxed immediately you must first of all place it into the exchange account.  

But then you have 180 days to use it to complete the purchase of the replacement real estate.  So if the buyer is willing to pay you completely within 180 days it could work.   But if the note is structured with more than a 180 day term and you cannot sell the note on the secondary market then it most likely will not work with your exchange.  Payments coming in after the exchange is over are going to be taxable.

The only options you have are to sell the note while the exchange is underway so that you can take cash to finish the exchange.  Or if you have cash sources outside you can replace the note with cash.  then you will have the cash to complete the exchange.

1031 exchanges are the tool to continue to defer the tax on your gain and to transition into passive assets until you pass the asset at death at a step up basis and the tax disappears for your heirs.

Installment sales will allow you to slow down the recognition of gain but not defer indefinitely.

It's difficult to mix the two but can be done with some sophisticated planning and some outside resources.

Thanks very much for your response.  I think you are 100%  correct that I can't dodge the depreciation recapture. 

And although I would like to avoid the majority of the remaining taxes, I'm not quite sure how to do that.   I need to get a down payment because I am selling at the top of the market, so the down payment will be taxable as well.  I was hoping to postpone some of the down payment---or breaking it down into a number of years.  But I'm not sure how that could be done.  

If I get no down payment, then the buyer may default---especially when the market crashes and the value plummets---and I really don't want to manage all these properties any longer.

I might consider taking the down payment (and whatever else is taxable) and buy something that isn't quite so hard to manage---like land or a very high end home.  

@Dave Foster , let's see if I am understanding what you are saying about 'replacing the note with cash' in a 1031.

Let's say I have Property #1 that I want to sell with Owner Financing for 400K. I took 100K depreciation and have 100K in appreciation, so let's say 25K in recapture tax and 20K in capital gains tax due. 

I sell Property #1 for 40K down as 'boot' to cover the recapture tax (40K - taxes + 25K) from the buyer and he/she also brings a bank loan for 180K and I carry 180K of seller financing over 20 years. 

Now enter Property #2 that I own. I do a cash out refi to get 200K from it (or it could come from other sources for that matter) and I put THAT 200K into the 1031, and take the seller financed note for 200K out in exchange for it. 

I then take the 360K and reinvest that into a new property, and still have the 180K seller financed note which is now 'outside of' the 1031 and collect payments over time? I assume that this would then be taxable with the interest portion as ordinary income and the principal payments would be taxed on 25% of that payment (the same as the ratio at sale time of property #1)? 

@L S. It sounds like you have multiple properties to sell maybe? Can you spread the sales over a number of years to help you achive your goals?

Dan Dietz

@L S I have also seen mention on hear of using a method where it sounds 'similar' to a 1031 but the facilitator hold the property for YEARS (I think determined by the seller/buy) and makes yearly payments to the seller. 

I dont remember the name of it, but maybe others on here can chime in. 

Dan Dietz

@Daniel Dietz Almost dead on!!!!  But it's even a little better than you described.  You don't have to take the $40K in boot if you don't want to because you are going to be completing a full 1031 exchange so you don't have to recapture depreciation in the year of sale (the 1031 deferred all the gain and depreciation recapture).  So you sell for $400 and you buy for $400 using the $400 in cash in your exchange account ($220K from buyer as down payment, and $180K that came from you buying your note out).

Yes, once you've exchanged the note with cash from anywhere that note is now not taxable except for the interest portion of each payment.

Thanks @Dave Foster , I think I am slowly getting the hang of it :-) 

I missed the point of even the 'capital gains' that was 'swapped out' not being due either.... makes sense now. 

I dont think I will need it for a while, but I will likely have a seller or two that I have been working on get in touch with you so they can better understand the possibilities. 

Thanks, Dan Dietz

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