Can I carry a note for my buyer and still do a 1031 exchange?

Whoever the note names at closing decides the whole outcome

A promissory note running to you is property you received on the sale, and you received it the day the deed recorded. Nothing the intermediary does afterwards undoes that, which is why Legal 1031 states that 'the note must be made payable to the Qualified Intermediary at the relinquished property closing' if it is to stay inside the exchange.

The assignment and the exchange agreement have to be signed before the closing, the purchase contract should say the note and deed of trust run to the intermediary as your assignee, and the title company needs that instruction in writing while it is still drafting documents.

If your contract already names you as payee, amend it. This is the one seller-financing mistake that cannot be repaired after the fact.

Four routes once the intermediary holds the note, and what each one costs

IPX1031 sets out the menu, and the choice is usually driven by how much outside cash you have and how patient the replacement seller is.

The buy-back is the most common and the most misunderstood. You pay the intermediary the face amount from money that has never been inside the exchange, the intermediary now holds cash instead of paper, and the whole sale price is available for the replacement. IPX1031 cautions that an exchanger 'should only use this method upon the advice of their tax or legal counsel', because the buy-back has to be genuine and priced at face.

A fifth possibility exists where the note is short. A buyer who takes a ninety-day carry can pay it off before the replacement closes, in which case the cash simply arrives in the intermediary's account and nothing unusual happens.

• Intermediary sells the note to a third party for cash: full deferral, less whatever discount the buyer of the paper demands.
• You buy the note from the intermediary at face with outside cash: full deferral, and you hold a note with a cost basis equal to face, so later principal is a return of capital.
• Intermediary uses the note as consideration to the replacement seller: full deferral, but the seller has to want the paper.
• Intermediary assigns the note to you at the end: the note is boot, reported under §453 as the buyer pays.
• Buyer retires a short note before the replacement closing: cash into the exchange, no special handling.

Example 4 of the regulation is the authority for taking the note as installment boot

The regulation's facts are almost exactly a seller carry-back. In Reg. §1.1031(k)-1(j)(2)(vi), Example 4, B transfers property through an intermediary to a buyer for '$80,000 in cash and D's 10-year installment obligation for $20,000', and the intermediary later delivers an $80,000 replacement property plus the note to B.

The conclusion has two halves. First, '$20,000 of B's gain (i.e., the amount of the installment obligation B receives in the exchange) does not qualify for nonrecognition under section 1031(a)' — the note is boot. Second, 'B's receipt of the obligation is not treated as a payment', so subject to §§453 and 453A, B 'may report the $20,000 gain under the installment method on receiving payments'.

That is a genuine choice, not a failure. You defer the like-kind portion under §1031 and spread the note portion over the years the buyer pays, with §453(f)(6) reducing the contract price and gross profit by the property you received without recognition.

Worked example: a $2,000,000 sale with $1,600,000 down and a $400,000 five-year carry

Assume a $2,000,000 price, a $700,000 adjusted basis, $120,000 of exchange expenses, and a buyer who needs you to carry $400,000 with interest-only payments and a balloon in year five. Realized gain is $1,180,000.

Route one: the note is payable to the intermediary and you buy it from them for $400,000 of savings before the replacement closing. The intermediary funds a $1,880,000 replacement, nothing is recognized, and the buyer's later payments are interest income plus return of the $400,000 you paid for the paper.

Route two: you take the note at the end. The $400,000 is boot, you reinvest $1,480,000, and the gain attributable to the note is reported on Form 6252 as principal arrives, which in an interest-only deal means almost all of it lands in year five. Round hypothetical figures, shown to compare the mechanics.

• Buy-back route: $400,000 of outside cash in, $1,880,000 reinvested, nothing recognized.
• Installment route: $1,480,000 reinvested, $400,000 of boot spread across the payments.
• Either way, the balloon paid in year five is cash from a note, not sale proceeds, and cannot start a new exchange.

The parts of the bill that the note cannot postpone

Section 453(i) is the one that surprises people: 'any recapture income shall be recognized in the year of the disposition, and any gain in excess of the recapture income shall be taken into account under the installment method'. Recapture income is what §1245 or §1250 would have produced if every payment arrived at once, so a cost-segregated building can generate an ordinary-income bill in year one against almost no cash.

Section 453A adds an interest charge where the sales price exceeded $150,000 and 'the face amount of all such obligations held by the taxpayer which arose during, and are outstanding as of the close of, such taxable year exceeds $5,000,000', computed at the §6621(a)(2) underpayment rate.

And the election out under §453(d) has to be made by the extended due date of the year-of-sale return, so the decision to spread or to accelerate belongs to that filing, not to a later one. Run both versions with your CPA or attorney before you sign the note.

Deal points to settle before the note is drafted

Most of the damage here is done in the purchase agreement, weeks before anyone talks to an intermediary. Fix these while the terms are still open.

Breakwater Exchange is a 1031 exchange broker with more than twenty years of experience and over a billion dollars in DST transactions, and a partly financed sale is one of the cases where a small, fast-closing Delaware Statutory Trust position can absorb the cash half while the note is dealt with separately (how quickly a DST can close).

• Payee and assignment language naming the intermediary, agreed in the contract, not at the closing table.
• Whether you will fund a buy-back, and where that cash sits today; it must never touch the exchange account.
• Term and amortisation: an interest-only balloon concentrates the boot in one distant year.
• Whether the buyer is a related party, which brings §453(e) resale rules and the related-party 1031 limits into play.
• Adequate stated interest, so the note is not recharacterised, and a payoff that does not fall due inside your 180 days if you intend to buy it back.