Does seller financing on the replacement count as replacement debt?

The netting rule counts any liability you take on, not only a bank loan

When your sale pays off a mortgage, Reg. section 1.1031(d)-2 treats the relief as money received. Reg. section 1.1031(b)-1(c) then offsets 'consideration given in the form of an assumption of liabilities (or a receipt of property subject to a liability)' against that relief. Neither cares who the creditor is.

Publication 551 puts it in plain terms for exchanges: decrease basis by liabilities 'assumed by the other party (or paid off in a deferred exchange)' on the property given up, and increase it by 'any liabilities you assume (or new debt incurred) on the like-kind property received'. A seller carryback note is new debt incurred on the property received. The full netting picture is on boot netting rules.

Interest-only terms, a short balloon or a second-position note all count at their principal amount

What matters is the principal you owe when the replacement closes. A five-year interest-only note with a balloon covers the same debt as a 25-year amortizing bank loan of the same principal. A seller second behind a bank first also counts; you add the two.

The interest rate matters in a different way. Section 483 treats part of the payments under a contract for the sale or exchange of property as interest when the contract has 'total unstated interest', so a zero-interest or very low-rate note can carry less principal for tax purposes than its face amount. Have your CPA check that the stated rate is adequate before you sign.

Worked example: a $400,000 seller note replaces a $400,000 mortgage

Hypothetical, round numbers, costs ignored; run your own numbers with your CPA. You sell a rental for $1,000,000; $400,000 pays off your mortgage and $600,000 goes to your intermediary. You buy a $1,000,000 replacement, paying $600,000 of exchange money and signing a $400,000 interest-only note to the seller, due in five years.

Debt relieved is $400,000; debt incurred is $400,000. They offset, no cash came to you, and nothing is recognized. On Form 8824 line 15, net liabilities assumed by the other party are the excess over 'any liabilities you assumed', which here is zero.

Change one fact: the seller will carry only $350,000 and you add no cash. Net debt relief is $50,000, which is money received, recognized up to your realized gain. Adding $50,000 of your own cash would fix it, because cash you pay offsets debt relief under the same regulation; see replacing the mortgage or adding cash.

A seller note cannot cover cash you keep, and it has to be a real debt

Reg. section 1.1031(d)-2 is explicit: 'consideration received in the form of cash or other property is not offset by consideration given in the form of an assumption of liabilities'. If your intermediary still holds money after the purchase, a larger seller note does not shelter it; see whether more debt offsets cash taken out.

Make the note look like what it is: a signed promissory note, a recorded mortgage or deed of trust, market terms, and the note shown on the settlement statement as part of the price. The borrower should be the same taxpayer that sold. A note the seller is expected to forgive, or that you plan to pay off from proceeds of the same exchange, invites the question of whether it was ever debt.

This is the mirror image of carrying a note for your own buyer, which is a different problem entirely: that note is not like-kind property; see carrying a note for the buyer.

If no seller will carry paper, a trust interest can supply the debt instead

Seller financing is one way to cover the debt leg without a bank. Another is a Delaware Statutory Trust interest whose property already carries non-recourse financing, a share of which is allocated to you; see whether a DST's loan counts as replacement debt. Our cash out DST structures are high-leverage trusts designed to solve debt requirements with a small portion of proceeds; they pay no current distributions, and you can lose invested capital.