Seller financing is a common practice in real estate transactions. In this unique form of lending, the seller of an investment property also functions as the buyer’s mortgage lender.
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There are many reasons why seller financing is used to help a buyer acquire an investment property. The buyer avoids the lengthy and onerous qualification process with a traditional mortgage lender, and the buyer also may be able to acquire a higher-priced property by pursuing seller financing instead of traditional lending opportunities. Deals can get done quickly without the messy complications and reams of paperwork that are typically required when a buyer takes on mortgage debt.
Seller financing works differently in a 1031 exchange than in a straight real estate sale, though. Keep reading to learn how to use seller financing in your exchange without violating IRC Section 1031 regulations.
How Seller Financing Works in Real Estate Transactions
Obtaining a commercial property loan became more difficult following the subprime mortgage crisis that crippled the economy during the late 2000s.
Oftentimes, property owners will sell assets directly to buyers without using traditional mortgage lending either to speed up the closing process or to side-step the rigorous loan qualification criteria. Owner financing is also referred to as seller financing or a purchase-money mortgage agreement.
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In this arrangement, the seller finances the bulk of the purchase, and the buyer pays the seller back in predetermined monthly installments. Seller financing can be beneficial for buyers because they may avoid expensive closing costs, high-interest rates, and property appraisals. Sellers also can be flexible in their requirements for a down payment, while down payment requirements through conventional lenders can range anywhere from 10 to 25 percent depending on the method of financing.
Seller financing can also be completed within a compressed time frame to ensure adherence to a closing date. If the buyer does decide to obtain conventional financing prior to closing, that note can simply be substituted for seller cash at the closing table.
How Seller Financing Works in a 1031 Exchange
Property owners who agree to seller financing in their 1031 exchanges must be extremely careful about how the deal is structured to avoid running afoul of IRS regulations regarding the constructive receipt of funds during the exchange process..
One of the most important aspects of successfully completing a 1031 exchange is the use of a qualified intermediary to avoid taking receipt of any sale proceeds during the exchange. Doing so before the exchange is completed will likely disqualify the transaction and result in a straight sale. In this instance, any realized capital gains from the disposition of the relinquished asset would immediately be taxable, the IRS reports.1
In a straight sale, there’s no conflict with seller financing and having the seller carry back the buyer’s note. But in a 1031 exchange, taking receipt of that note would constitute receipt of money or other property and result in a straight sale instead of a deferred exchange. In this instance, the mortgage note would be considered taxable.
There are, however, some ways to avoid this scenario.
How to Arrange Seller Financing in a 1031 Exchange
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In order to enjoy safe harbor in a seller-financed 1031 exchange, the mortgage note must not be issued to the buyer; instead, it must be issued in a qualified intermediary’s (QI) name.
With the note written out to the QI, the parties now can use the value of the note to purchase the replacement property. Since neither party takes receipt of funds during the transaction, the exchange remains valid. Sometimes in a seller-financed exchange, the seller will request the buyer to add some form of personal guaranty to the note in order to decrease default risk, but there’s no legal requirement for the buyer to provide any additional assurances to the seller. Another method is for the buyer to purchase the note with cash, either from personal resources or a traditional loan. The buyer can then put these additional funds into the exchange transaction.
Timing is extremely important when arranging seller financing. The safest course of action is to assign the note at the same time or after the replacement property has been acquired so that neither party takes receipt of funds during the exchange.
Putting it all Together
Having sellers carry back a promissory note can be a powerful tool during a real estate transaction. Buyers and sellers need to plan in advance if they intend to structure an exchange transaction using seller financing so they can enjoy safe harbor and avoid breaking any IRS rules that would disqualify their exchanges.
Using seller financing in a 1031 exchange can be complicated. Investors considering this approach should engage the services of accountancy and legal professionals with experience in 1031 exchange laws and regulations to ensure full compliance with IRS exchange regulations.
1 Like-Kind Exchanges Under IRC Section 1031, IRS.gov, https://www.irs.gov/pub/irs-news/fs-08-18.pdf
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