Here are a few pro tips for dealing with 1031 exchanges that involve contracts for deed.
Purchasing Replacement Property is Generally OK
Generally, one can purchase 1031 replacement property on a contract for deed.
From an accounting perspective you may need to use all of your exchange funds as the down payment on the instalment.
For federal tax purposes the vendee on the contract for deed generally is deemed to be the (equitable) owner, and the vendor is merely holding bare legal title as an enforcement mechanism to compel payments and full performance of the vendee. Contracts can differ depending on terms – but this is generally the case.
Selling is More Complicated
Selling on a contract for deed (or even seller-back promissory note) is more complicated (with a 1031).
First, in the event that the taxpayer/seller actually receives or constructively receives the seller carry-back note or paper, then that amount of non-cash proceeds may nevertheless be recognized and trigger gains, which may occur on the instalment basis. This is where you need a good qualified intermediary. Also, it should be noted that portions of gain related to deprecation recapture cannot be deferred under the instalment method according to Sections 751, 1245 and 1250, and the taxpayer/seller may have recognize the deprecation recapture as ordinary income in the year of sale. This is a potentially big trap for the unwary for part 1031 and part instalment sales.
If the taxpayer wants to use the installment note to acquire replacement property, they must recognize the inherent difficulties of persuading a seller to take the paper and attempt to persuade the seller of the replacement property to accept an allonge of the third party note as partial payment for the replacement property. An allonge is typically given to a successor lender when a seller-back note is assigned in full or partial consideration for the purchase of the Replacement Property.
Another possibility if the taxpayer/seller has enough cash to contribute to the transaction available at the time of the closing of the Relinquished Property, is to have the taxpayer/seller fund the loan to the buyer out of other sources (out-of-pocket), rather than the sale proceeds, and offset any amount loaned to the purchaser of the relinquished property; that way the same amount of equity will go to the qualified intermediary as would normally occur if there was no seller-back loan.
Find a Qualified Intermediary for Your 1031 Exchange
Find a qualified intermediary for your like-kind exchange by reaching out to the team at CPEC1031, LLC today! We have several decades of experience working with a wide variety of taxpayers on their 1031 exchanges. We can help by answer any questions you may have about the 1031 process, preparing the appropriate documentation, and acting as your neutral third-party in the exchange. Contact our team of like-kind exchange professionals to get started on your next 1031 exchange of investment or business real estate.
Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.
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