How does seller financing work?

[Aaron Horn]

Hey everybody! So here's the scoop. A friend of mine has enough cash for a full 20% down on our first property with plenty left over for reserves and upgrades. We found a decent duplex that could use a little bit of work and would generate decent cash flow. But that's not why I'm here. His parents recently moved out of their house and into a new nicer house right across the street form their old one. They still own their first house and are renting it out to his sister and her friends in college. It's a 3 bed 1 bath SFH located within walking distance of two colleges. His parents plan on putting it up for sale at the end of the December. I've heard that it's possible to user seller financing so the sellers get paid and the buyers have to put very little or none down. I haven't done a whole lot of research because I figured seller financing would be a few years down the road but the opportunity arose and if it's possible I'm going to take it! Since we have a good relationship with the sellers, convincing them to finance the house for us shouldn't be too difficult if the numbers make sense for us as well as them. If we manage to get the SFH with no money down we can then sink most of our funds into the duplex as well, giving us 3 units instead of just the 2 for the same price. So if it's possible, what's the best way to go about doing this?

[Bill Exeter]

Seller financing can be structured with a 1031 Exchange, but the seller must understand that it will complicate their 1031 Exchange transaction.  Careful thought must be given to exactly how you want to structure the seller carry back note as part of the 1031 Exchange so that you can take full advantage of the 1031 Exchange.

Generally, when structuring a normal 1031 Exchange without a seller carry back note, the Qualified Intermediary receives 100% net cash proceeds upon closing of the sale and can then easily move forward with the purchase of the replacement property.

However, when structuring the sale with a seller carry back note, there will not be all cash available at closing without proper planning.  There are a number of ways to structure the transaction when a seller carry back note is involved.

The best method, if the seller has sufficient cash from other sources, would be to act as the lender.  In other words, if the seller is going to carry back $200,000 in a promissory note, the seller would deposit $200,000 into the closing just like a lender would do.  The seller carry back note (promissory note and corresponding deed of trust or mortgage) would be drafted in the seller's name (as the lender).  The Qualified Intermediary would then receive 100% cash at the closing and can proceed with the purchase of the target replacement property in the 1031 Exchange.

However, sellers often do not have that kind of extra cash laying around, so the seller cary back note must be drawn in the name of the Qualified Intermediary if they want to defer all of their tax consequences.  This means that at the closing the Qualified Intermediary is now holding some cash and the seller carry back note.  The difficult part is how do you proceed with the acquisition of the replacement property when you do not have all cash.  The note can be bought out of the exchange account later by the seller/taxpayer if they can obtain cash at a later date.  The note can be sold to anyone else, but generally at a pretty steep discount.  The note could be used as part of the consideration paid toward the purchase of the replacement property, but most sellers of the replacement property will not be interested in a third-party note. 

So, as you can see, using a seller carry back note can be a very good strategy to get a deal done, but it will make the 1031 Exchange more complicate - even impossible in some cases.