Deferred taxes on a Creative Finance deal

9 Replies

Hi Everyone, 

I'm looking for advice on deferred taxes on a possible hybrid creative finance deal I'm trying to put together on an off market property. 

This is the current situation:

House is 250K ARV, built in 1990, good middle class neighborhood in Indianapolis, house is in good condition, currently rented till March. Seller still owes 108K on the mortgage but has a good chunk in equity. He has been renting out the house 20 some years and also has been depreciating the property. He wants to sell but is hesitant because of capital gains tax that he may be hit with if he sells. I talked to him about a 1031 exchange as a possibility, which he may consider but he also has additional questions as to how the taxes play into a creative finance structure.

Given that he wants close to market value, its a good property and he wants to sell without being hit capital gains, I thought this might be a perfect situation for a creative finance. 

I'm a newbie in this area, and would like advice as to how to structure a hybrid deal. Also, what kind of structure would help him mitigate or defer taxes he may own if we go this route. 

I have to call him with a proposal of a deal. So, if anyone has advice for me I'd greatly appreciate it. Moreover, if anyone is interested in this deal to add to their portfolio and would like to work the deal with me, that's also welcome. 

Thank you for your time, patience and advice.

Mark Jaret

Originally posted by @Jaret Lara :

Hi Everyone, 

I'm looking for advice on deferred taxes on a possible hybrid creative finance deal I'm trying to put together on an off market property. 

This is the current situation:

House is 250K ARV, built in 1990, good middle class neighborhood in Indianapolis, house is in good condition, currently rented till March. Seller still owes 108K on the mortgage but has a good chunk in equity. He has been renting out the house 20 some years and also has been depreciating the property. He wants to sell but is hesitant because of capital gains tax that he may be hit with if he sells. I talked to him about a 1031 exchange as a possibility, which he may consider but he also has additional questions as to how the taxes play into a creative finance structure.

Given that he wants close to market value, its a good property and he wants to sell without being hit capital gains, I thought this might be a perfect situation for a creative finance. 

I'm a newbie in this area, and would like advice as to how to structure a hybrid deal. Also, what kind of structure would help him mitigate or defer taxes he may own if we go this route. 

I have to call him with a proposal of a deal. So, if anyone has advice for me I'd greatly appreciate it. Moreover, if anyone is interested in this deal to add to their portfolio and would like to work the deal with me, that's also welcome. 

Thank you for your time, patience and advice.

Mark Jaret

What zip code are we talking about?  Check into Land Contract and Lease Option. Both are tax friendly. Just depends on what you want to do and what tolerance you each have. 

@Jaret Lara , Any amount that he finances he will pay tax on.  An owner carry will spread the taxes out but he will pay the taxes.  

A 1031 exchange will defer all taxes and depreciation recapture.

In between those there is the possibility of a 1031 and owner carry.  Whatever he carries back he pays taxes on spread out over the term.  But if he puts the owner carry note into the exchange and while the exchange is going, replaces the note with his own cash he can also include the note in the 1031.  So he can truly carry some financing and still defer all tax.

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Hi @Jaret Lara

There are options, but the most important thing is for the investor to meet with his tax advisor to discuss the options.  The investor may have other income tax issues involved that might change the answer (tax loss carry forwards, suspended passive activity losses, etc.).  

Here are some ideas: 

  • Sell property with a seller carry back note (seller financing).  The amount of cash put down would be taxable in the year of sale.  The remaining taxable gain is generally deferred over the term of the note and recognized each year based on the percentage of principal that is paid down each year.  The positive is that it could put him in a lower tax bracket for the taxable gain, but the taxable gain would be recognized. 
  • Sell property with a seller carry back note (SCBN), but include the SCBN inside of a 1031 Exchange.  There are a number of ways to do this.  The investor can (1) advance the funds to "fund" the SCBN (seller lends money) so that the 1031 Exchange has all cash to complete the 1031 Exchange; (2) sell the SCBN held in the 1031 Exchange to convert the SCBN to cash (buyer's often want significant discounts) so that the 1031 Exchange has all cash to complete the 1031 Exchange; or, (3) find replacement property where the seller is willing to accept an assignment of the SCBN as part of the consideration for the replacement property.  This would allow for a full tax-deferred transaction, but is not easy and/or practicable.  It is good for the buyer, but complicates the investor's/seller's 1031 Exchange. 
  • Sell property through a 1031 Exchange with no SCBN.  This would be a straight Forward 1031 Exchange.  This would allow for a full tax-deferred transaction. It is good for the investor/seller, but not as favorable for the buyer trying to structure the purchase. 
  • Sell property and cash out.  This will trigger the taxable gain.  However, they could defer the payment of the taxes by investing in a Qualified Opportunity Zone Fund.  This would defer the gain under the present law to 12/31/2026.  The taxable gain would be taxed/due on the 2026 tax return.  Any gain on the new QOZ Fund investment(s) would be tax free if held for ten (10) plus years.  
  • There are other strategies as well, but these are the more common ones in use. 

@Dave Foster Thank you for taking the time and advice. Sounds like a 1031 exchange is the simplest form and would be the best option for him as to the taxes. 

Now with regards to the second option, can we do a subto on his mortgage and then 1031 the amount he will carry? If so, how does the 1031 exchange work in this case? Does he still have to buy another property with amount he is getting from the owner carry?

@Jaret Lara , The simplest form of a 1031 starts with the closing of a sale (deed transfers) and ends with the purchase of a piece of investment real estate (a deed transfers).  An IRS field agent can get their arms around this - usually!

But the transfer of the deed is not necessarily the only criteria that would meet the definition of a "sale" or "purchase" of real estate.

The doctrine that the IRS accepts is the definition of "risk of loss" passing.  If enough of the burdens and benefits of ownership transfer from seller to buyer that can be considered a sale or purchase even if the deed does not transfer.

A land contract is an example.  A sub 2 would be another if structured correctly.The burdens and benefits of ownership transfer so it can be considered a purchase even if the deed does not actually convey because of the loan.  

In your example he would be selling a piece of real estate to you and starting a 1031.  If your legal team agrees that risk of loss passes with the signing of the contract then his 1031 starts with that event.

But he only has 45 days from that date to identify his potential replacements and a total of 180 days to close.  And he will only have your down payment available to put in the 1031.  Once the 1031 starts any future cash payments cannot be part of that 1031.  Only what is conveyed at the time of closing.

So long term sub 2s don't work really well as 1031 candidates generally.

Hi @Jaret Lara

There are really two key computations/requirements here.  The first is the Net Sale price (Gross Sale price less certain routine selling expenses).  The total amount of replacement property acquired must be equal to or greater than what he sold (this includes equity and debt).  The total amount of equity that was generated from the sale of the relinquished property must be reinvested in the new replacement property(ies), too. In short, he must trade equal or up in value, including all proceeds whether cash or debt. 

@Jaret Lara , It would certainly decrease his basis and artificially increase his taxable gains.  And if he doesn't do a full 1031 and carries back some financing he'll probably have to recapture all of the amount of that note as depreciation.  So a hybrid approach is much less valuable to him rather than a straight up sale and 1031.

This could be in your favor as the only way to get out of his position without a lot of tax will be to sell completely to you.  So maybe there's a price adjustment that could be used so you can qualify for external financing??