1031 Exchange With Installment Sale Note

An IRS Section 1031 exchange is a tax deferred exchange of one investment property for another. When a property is sold in a 1031 exchange, the seller can defer paying capital gains taxes on the sale if they reinvest the proceeds in a similar property. This means that the seller can use the proceeds from the sale to acquire a replacement property or properties without paying taxes on the gain from the sale of the relinquished property.

If the seller receives an installment sale note (section 453) as part of the proceeds from the real estate transaction, they can include the note in the 1031 exchange. This means that the seller can defer paying taxes on the gain from the sale of the property until the note is paid off, as long as the note is exchanged for a similar investment property.

Here's how it works:

The seller sells their investment property and receives the proceeds from the sale, which may include an installment sale note. The seller must work with a qualified intermediary (QI) to handle the exchange.

The seller identifies the replacement property or properties within 45 days of the sale of the relinquished property. The seller must provide a written description of the replacement property or properties to the QI, who will hold the proceeds from the sale of the relinquished property in a separate account.

The seller assigns the installment sale note to the QI, who will hold the promissory note until it is exchanged for a similar investment property. The note must be secured by a mortgage or deed of trust on real property, and must be payable over a period of at least two years at a market rate of interest.

The QI uses the net cash proceeds from the sale of the relinquished property, including any proceeds from the installment sale note, to acquire the replacement property or properties. The note must be exchanged for a similar investment property, which means that the replacement property or properties must have a value equal to or greater than the value of the note.

The seller defers paying taxes on the gain from the sale of the relinquished property until the note is paid off. However, any gain on the note will be recognized in the year that the note is paid off, so the seller will owe taxes on that gain at that time.

The seller must comply with the other requirements of a 1031 exchange, including the 180-day time frame for acquiring replacement property or properties, and the rules regarding like-kind property.

Some additional things to keep in mind:

Including an installment sale note in a 1031 exchange can be a complex process that requires careful planning and compliance with the rules and requirements of the 1031 exchange process. It's important to work with a qualified intermediary and a tax professional to ensure compliance.

The seller must identify replacement property or properties within 45 days of the sale of the relinquished property and must acquire the replacement property or properties within 180 days after the sale. The QI will use the proceeds from the sale of the relinquished property, including any proceeds from the installment sale note, to acquire the replacement property or properties.

If the seller does not acquire a replacement property or properties that are equal to or greater in value than the installment sale note, the seller will owe taxes on the gain from the sale of the relinquished property.

There are ways that you can circumvent paying taxes on the "boot." You can either:

A: Add funds to the exchange (not always ideal, but still doable for some)

B: Purchase a zero coupon DST (cheap way to purchase debt)

C: Consider a qualified opportunity zone fund

D: Include a deferred sales trust as part of your exchange (Depending on the situation, during seller financing, you're able to roll the note and the installment payments into a deferred sales trust. Depending on your income needs, you can reduce your income stream and let those payments keep growing tax-deferred)

E: Some combination of the above.

In summary:

Including a section 453 structured installment sale note in a 1031 exchange can be a useful tool for deferring taxes on the gain from the sale of an investment property, but it requires careful planning and compliance with the rules and requirements of the 1031 exchange process.

Sera Capital helps clients by acting as a fee-only fiduciary focusing on tax-efficient exit planning. We offer DST 1031 exchange services through special situations where investors could put 1031 real estate into a securitized property while deferring taxes.

Schedule a free 30-minute call today.