Seller Financing
Section 1031 of the Internal Revenue Code (IRC) permits you to sell your investment property, called Relinquished Property, and defer taxes on your Capital Gains and Depreciation Recapture, if you purchase another investment property, called your Replacement Property, within 180 days.
Section 1031 Exchange Rules
Section 1031 Exchange rules require that the purchase price of your Replacement Property be equal to, or greater than, the sales price of your Relinquished Property.
Section 1031 Exchange rules also require that you use all of your Net Sales Proceeds from the sale of your Relinquished Property in the purchase of your Replacement Property.
Section 1031 Relinquished Property
The question we are dealing with here is whether you can use Seller Financing in purchasing your Replacement Property.
In other words, can you have the Seller of the Replacement Property finance your purchase from him, instead of you getting a mortgage from a lender?
Let’s see how that would work.
Let’s use an Example, with simple numbers.
You bought an investment property for $130,000 with a $90,000 mortgage a few years ago.
You have claimed $30,000 in depreciation and you have paid the note down to $80,000.
Now you are selling the property for $300,000.
You have $200,000 in profit, the difference between the selling price and your adjusted basis.
$170,000 of this profit is true Capital Gains, the difference between what you paid for the property ($130,000) and what you sold it for ($300,000).
The other $30,000 of your profit is caused by the claimed depreciation which lowered the Basis in the property.
When you close on the sale, your $300,000 Gross Sales Proceeds will be reduced by the mortgage payoff of $80,000 and you will have Net Sales Proceeds of $220,000.
Now, let’s look at the second part of the transaction.
Seller Financed Replacement Property
Let’s say you purchase a Replacement Property for $410,000.
You must use the $220,000 of Net Sales Proceeds toward the purchase of the property, leaving $190,000 in funding that you must provide.
You can use your own cash for all or part of this amount.
You can get a loan from a lender for the entire $190,000.
You can sign a note back to the Seller for $190,000 and do Seller Financing.
Or you can use any combination of the three.
As long as you buy a Replacement Property of equal or greater value, and you use all of your Net Sales Proceeds in the purchase, it does not matter where or how you finance the rest of the property.
And this includes Seller Financing.