Can I sell a note and 1031 it into a property?

Question

Bill Exeter · Answer

Hi @Logan Turner,

Unfortunately, the sale of a promissory note and/or other "paper" is not considered to be a sale of real estate and would not qualify for 1031 Exchange treatment. In fact, Section 1031 of the Internal Revenue Code specifically excludes "notes" from 1031 Exchange treatment.

The sale, conversion or hypothecation of the seller carry back note would trigger any deferred gain that might exist in the note.

Bill Exeter · Answer

Hi @Ronald Lambert,

Yes, once you have foreclosed on the property and actually own an interest in real estate, you could qualify for 1031 Exchange treatment. Keep in mind that one of the requirements to qualify for 1031 Exchange treatment is that you have the intent to hold the property for rental, investment or business purposes. The risk or issue would be that if you foreclosed on the property, obtained an interest in the real estate through the trustee sale, and then immediately sold the property it may be deemed that you did not have the intent to hold for rental or investment purposes and the 1031 Exchange could be disqualified. The safest approach would be to foreclose and obtain the interest in real estate, hold for a period of time to demonstrate that you did in fact have the intent to hold for rental or investment purposes, and then sell and structure a 1031 Exchange transaction.

Bob Malecki · Answer

Thanks @Bill Exeter, your comment about notes being personal property provides perfect clarity as to why it is disqualified in a 1031.

Bill Exeter · Answer

Hi @Zachary Taylor,

You are correct, mortgages (promissory notes) held inside the REIT would be specifically excluded from 1031 Exchange treatment.  REITs can exchange real estate assets, but not promissory notes.  The IRS does not recognize the mortgage asset as real estate.  The REIT just holds title to non real estate related investments and they investments must be accounted for just like any other real estate asset held in a REIT (i.e., accounting, distribution of profits, etc.), but it does not mean that the mortgages qualify as a real estate interest.  The mortgage is still a personal property interest (i.e., non-real estate) .

Bob Malecki · Answer

Hi Bill, can we assume that notes/paper cannot be exchanged via 1031 at all,  even if it is a note-to-note exchange?

Bob

Dave Foster · Answer

@Logan Turner, If you haven't closed that sale yet then there is a way to do it.  But if you have transferred the property Sorry but no on several levels

1. 1031 on the real estate side is a sale of investment real estate followed by a purchase of real estate.  Your note would not be like kind.

2. The note would also be a financial instrument and not eligible for 1031 into another note.  And the note is to a related party so that's a non starter anyway.

Ronald Lambert · Answer

Excellent input @Bill Exeter, thanks

Ronald Lambert · Answer

@Let me twist the question a bit.  If I own the note, then end up having to foreclose and take back the property, I then am the property owner.  Can I 1031 exchange from there?

Don't get me wrong, I would not do that on purpose just to get the house!  But wondering....

Bill Exeter · Answer

Hi @Bob Malecki,

Yes, you are right on the money.  Notes are specifically excluded from 1031 Exchange treatment, so even exchanging notes for other notes would not qualify.

Can I sell a note and 1031 it into a property?

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