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SELLER FINANCING SECTION 1031 EXCHANGES

 

Seller Financing 1031 Exchanges is permitted by Section 1031 of the Internal Revenue Code (IRC), which 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 Replacement Property.

If you need an Overview of how the Section 1031 Like Kind Exchange process works, go to the Home page where I have a complete explanation.

SECTION 1031 EXCHANGE RULES

Section 1031 Exchange rules require that the value of your Replacement Property be equal to, or greater than, the value of your Relinquished Property.

Section 1031 Exchange Rules also require that you use all of the Net Sales Proceeds from the sale of your Relinquished Property in the purchase of your Replacement Property.

There are more Section 1031 Exchange rules, and you can read about them here.

SECTION 1031 RELINQUISHED PROPERTY

The question we are dealing with here is whether you can use Seller Financing in 1031 Exchanges for your Replacement Property.

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.

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 represents your claimed depreciation.

For a refresher on depreciation, see Dictionary.

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.

SELLER FINANCING 1031 EXCHANGE 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 use bank financing for the entire $190,000.

You can sign a note back to the Seller for $190,000 and do seller financing. That would be seller financing a 1031 Exchange.

Or you can use any combination of the three.

Just be aware that after this is all over, you will have to file Form 8824 with the IRS, and that Form is very difficult to do even when everything is simple.

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 that includes the use of seller financing 1031 Exchanges.

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