Can I 1031 exchange a mortgage note, a tax lien or a land contract?

The regulation excludes debt instruments by type, so state law cannot turn them into real estate

Since 2018, section 1031(a)(1) reaches only real property. Most intangible interests get their status from state law under paragraph (a)(6) of the regulation, but paragraph (a)(5)(i) lists exclusions that apply 'regardless' of state law, including stock, bonds, notes, evidences of indebtedness, partnership interests, beneficial interests and choses in action.

A mortgage note is a promise to pay secured by land; the security does not make the note land. The same is true of a share in a mortgage fund, which fails twice, as a partnership or beneficial interest and as debt.

Even before 2018 the result was the same: Reg. section 1.1031(a)-1(a)(1) still recites the old exclusion of 'stocks, bonds, or notes' and 'other securities or evidences of indebtedness or interest'.

Tax liens and land contracts fail for the same reason, while the property behind them does not

A tax lien certificate entitles the holder to be repaid the delinquent tax with interest when the owner redeems. That is a claim to money, so it falls in the excluded categories while it remains a certificate. If the owner never redeems and you take a tax deed, you then own the land, and land you hold for investment can later be relinquished property. Auction-bought property as replacement is covered in auction, foreclosure and REO replacement property.

A seller who keeps legal title under a land contract holds security, not ownership. IRS Publication 537 lists a land contract among the forms a buyer's installment obligation takes. If you already sold that way, see I sold my rental on a land contract.

If the buyer defaults and you take the property back, section 1038 says 'no gain or loss shall result' from the reacquisition beyond a limited amount. The rental is then yours again, and a future sale can be set up as an exchange.

Notes still show up inside exchanges, but as boot or as financing, not as like-kind property

When your buyer pays partly with a note, the note is the non-like-kind part of the deal. Reg. section 1.1031(k)-1(j)(2) Example 4 has a buyer pay $80,000 cash and a $20,000 ten-year installment obligation; the $20,000 'does not qualify for nonrecognition' but may be reported on the installment method. How to keep the exchange intact around a note is in carrying a note for your buyer.

On the replacement side, seller financing is debt you take on, not property you receive, and it counts toward the debt you need to replace. Exchange proceeds cannot be lent to anyone or used to buy someone else's note.

Worked example: an investor tries to roll a $300,000 note into a rental

Hypothetical, round numbers; run your own numbers with your CPA. Years ago you sold a lot on the installment method with a 40% gross profit percentage. The buyer still owes $300,000, and you would like to swap that note for a duplex.

Publication 537 sets your basis in the note at the unpaid balance minus the profit still owed: $300,000 minus 40% of $300,000, or $180,000. Sell the note to an investor for $280,000 and the gain is $100,000, reported that year with the character of the original sale. No intermediary can change that, because the note was never eligible property.

Keep collecting instead and you report 40% of each principal payment as it arrives. Either way, the duplex is bought with after-tax cash.

• Unpaid balance $300,000, profit owed $120,000, basis $180,000.
• Sale of the note at $280,000: $100,000 of gain now.
• Collect to maturity: $120,000 of gain over the remaining payments.

If you want real estate exposure from note money, it has to come through a real property sale

Paper investors who want to move into property have no exchange route from the paper itself. The deferral opportunity arises only when you sell real property you hold for investment; that sale can then buy any U.S. real property, including a fractional trust interest.

A Delaware Statutory Trust interest is real property for exchange purposes under Rev. Rul. 2004-86, unlike a mortgage fund unit, and carries its own risks of illiquidity, sponsor fees and no control. See traditional DST exchanges and the full list in what does not qualify for a 1031.