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SELLER CARRYBACK FINANCING: "NUMEROUS
OPTIONS ARE AVAILABLE IN §1031 EXCHANGES"
When an Exchanger elects to carryback a Note on the relinquished property
(the sale or Phase I Property), there are basically two options for
treatment of the Note:
(1) DO NOT include the Note in the exchange and pay any taxes that
may be due. The Exchanger would receive the Note as the Beneficiary at the
closing and pay taxes on this portion of the capital gain under the
Installment method (§453).
(2) Include the Note in the exchange by initially showing the
"Qualified Intermediary" (API) as the Beneficiary and possibly
defer the capital gain taxes. In option number (1), the Exchanger is
electing to take the Installment method per Code Section 453. The Note is
made payable to the Exchanger and is received by the Exchanger at the
closing of the relinquished property. The drawback to this method is the
capital gain tax could become due in one lump sum if the Note allows for
prepayments or if a balloon payment is required. In option number (2), the
Exchanger has four different alternatives for attempting to use the Note
as part of the tax deferred exchange. In order to avoid "constructive
or actual receipt" by the Exchanger, API is named as the Beneficiary
on the Note.
(A) Use the Note Towards the Down Payment on the Replacement Property
(Purchase or Phase II)
The Seller of the replacement property accepts the Note as partial payment
towards the purchase price. In this scenario, the Note is assigned to the
Seller by API and delivered to the Seller at closing.
(B) Exchanger Purchases Note From the Exchange
Essentially, the Note is to be replaced with cash. To avoid constructive
receipt of funds at the relinquished property closing, the Exchanger
deposits cash equal to the face value of the Note directly to the closing
officer. API assigns the Note to the Exchanger for delivery immediately
after closing on the replacement property.
(C) The Payer on the Note Pays Off the Note Prior to Closing on the
Replacement Property
The Note is actually paid off during the exchange. This works only on
short-term Notes due within the 180 day exchange period. The Payer pays
off the Note directly to API, the holder of the Note. API adds the payoff
proceeds to the existing proceeds in the Qualified Exchange Account. When
the replacement property is ready to close, all proceeds are delivered to
the closing officer.
(D) Selling the Note on the Secondary Market
The Exchanger finds an investor willing to purchase the Note, thereby
replacing the Note with cash. The cash proceeds are added to the existing
cash in the Qualified Exchange Account for purchasing the replacement
property. Typically the Note will need to be sold at a discount, often
anywhere from 15% - 30%. If the Note is discounted, the discounted amount
MAY be considered a selling expense.
If the Exchanger chooses option (2) and then is unsuccessful with any of
the four alternatives shown above, API will assign the Note back to the
Exchanger. The Exchanger has all the tax benefits of the installment
method in Code §453 as shown under option (1) available. Many Exchangers
choose option (2) because it allows for several alternatives of tax
deferral, without penalizing the Exchanger.
Back to Table of Contents 1031
Exchange Information
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