Seller Financing on Both Sides of an Exchange

A note from your buyer is boot, and the regulations let you report it as it is paid

Section 1031(b) taxes gain to the extent of money or other property received, and a buyer's promissory note is other property. Reg. section 1.1031(k)-1(j)(2)(ii) and (iii) then say that, where a qualified intermediary is involved, receiving the obligation of the person who bought from the QI is treated as receiving the buyer's own obligation for section 453 purposes, so it is not a payment when received.

The regulation's own example: a $100,000 sale for $80,000 cash and a 10-year $20,000 installment obligation. The $20,000 does not qualify for nonrecognition, but the seller may report that gain under the installment method as payments arrive. Section 453(f)(6) keeps the like-kind property out of the contract price, so only the boot is spread.

Two limits apply. Paragraph (j)(2)(iv) requires a bona fide intent to exchange at the start, meaning it was reasonable to believe replacement property would be acquired in time. And section 453(i) requires any ordinary recapture income under section 1245 or 1250 to be recognized in the year of sale, so a property with cost-segregated components can produce tax in year one even on a note.

A note you sign to buy the replacement is new debt and counts toward the debt test

If the seller of your replacement takes back a note secured by the property, that liability is part of what you pay. The Form 8824 instructions net liabilities assumed by the other party against "any liabilities you assumed" and cash you paid, and treat only the excess as boot. A seller carry-back can therefore replace a bank loan you paid off on the sale.

It also adds to your basis like any purchase-money debt. Its terms are yours to negotiate: rate, amortization, balloon and prepayment. Before relying on seller financing to meet the debt test, confirm with your CPA how the note will be reported on Form 8824.

Worked example: why the two notes do not cancel out

Hypothetical, round numbers. You own a free-and-clear building with a $400,000 basis and sell it for $1,000,000: $800,000 cash to the QI and a $200,000 note from the buyer. You then buy a $1,000,000 replacement with the $800,000 and a $200,000 note to the replacement seller.

Treas. Reg. section 1.1031(d)-2, Example 2 shows the rule: liabilities taken on offset liabilities relieved, but "only the consideration received in the form of cash" stays boot. Applying it here, you were relieved of no debt, so the $200,000 note you sign offsets nothing, and the $200,000 note you hold is boot. Of the $600,000 gain, $200,000 is recognized, reportable on the installment method as the buyer pays and $400,000 is deferred. Run your own numbers with your CPA.

The fix is to keep the received note from being boot at all. If the buyer's note is paid off or converted to cash held by the QI before you close on the replacement, the cash buys like-kind property and the replacement seller's note becomes ordinary acquisition debt.

Getting the note out of the exchange before the replacement closes

Three routes do that. None is spelled out in the regulations, so have your CPA or attorney review the one you choose before you sign. The note should be made payable to the QI at the sale closing, not to you, so the QI holds it under the exchange agreement.

Paragraph (g)(4)(vii) lets you receive money or property directly from a party other than the QI without breaking the safe harbor, but a note taken in your own name at closing is simply boot and cannot be used later. Carrying a note for your buyer covers the single-sided version of this decision.

• Buyer pays early: the buyer refinances or pays the note to the QI before your replacement closes, and the cash goes into the purchase.
• You buy the note: you pay the QI the note's face amount in cash from outside the exchange, the QI uses that cash for the replacement, and you hold the note outside the exchange.
• Note as purchase money: the replacement seller agrees to accept the buyer's note as part of the price, so the QI assigns it at closing.

When seller financing helps the exchange, and when a DST is simpler

Seller financing on the sale can widen your buyer pool and earn interest, but it ties up gain until collection and leaves you exposed to the buyer's default. Seller financing on the purchase can speed closing because there is no lender timeline. If the goal is a smaller, safer debt position, compare it with deleveraging with a 1031 and installment sale vs 1031.

Interest on either note is ordinary income or expense, separate from the exchange. If you would rather replace debt without signing a personal note, a cash out DST uses non-recourse financing held at the trust level, with all operating income servicing the loan and no current distributions; it is illiquid and leveraged. Advanced boot tax planning covers other ways to manage the boot that remains.