Tax-deferred exchanges are frequently combined with seller financing of the relinquished property. This creates a possible installment sale transaction in which a promissory note, issued by the buyer for the benefit of the seller/taxpayer, represents a portion of the purchase price.

For example, if the relinquished property value is $100, the taxpayer might receive $50 in cash and a $50 note from the buyer. In this circumstance, the taxpayer would ideally like to use the proceeds in a tax-deferred exchange, while also benefiting from potential installment sale reporting on the note.

However, at the outset the taxpayer must address an initial hurdle imposed by the installment sale reporting rules. IRC §453 requires that the note must be received from the party “acquiring the property” from the taxpayer [IRC §453(f)(3)]. If the note were received from someone other than the buyer, the note would then be immediately taxable. In the context of a §1031 exchange this creates an issue because most like-kind exchanges are facilitated by a qualified intermediary (QI). The QI, for purposes of §1031, acquires the relinquished property from the taxpayer and transfers it to the actual buyer. This particular conflict is resolved by the like-kind exchange regulations, which provide that the taxpayer may receive the buyer’s note in an exchange transaction, and the taxpayer may treat the note consistent with the installment sale rules of §453 [Reg. 1.1031(k)-1(j)(2)(ii)].

Transactional Structures Within §1031

As taxpayers attempt to coordinate the aspects of the §1031 exchange transaction with the installment sale rules, the taxpayer’s treatment of the installment note can be handled in several ways:

Method 1

The buyer of the relinquished property may issue the note to the taxpayer at the closing of the relinquished property sale, and the note may be delivered directly to the taxpayer. In this structure the taxpayer may attempt to fragment the transaction into 1) a §1031 exchange on the interest in the property represented by the value of the cash proceeds received, and 2) a sale of the remaining interest represented by the installment note.

Example: If the relinquished property value is $100, the taxpayer might receive $50 in cash and a $50 note from the buyer. Fifty dollars in proceeds would be placed with the QI and any gain on this amount would be deferred through a §1031 exchange. The taxpayer could also receive installment sale treatment of the $50 represented by the note, and the gain would be deferred through the allocated reporting period.

Although this structure does allow the taxpayer a high level of flexibility, it should be noted that there is no case law or ruling supporting this structure, and it is potentially subject to attack as step transaction [see Commissioner v. Court Holding Co., 324 US 331,89 L.Ed. 981, 65 S.Ct. 707 (1945)].

Method 2

Alternatively, the taxpayer may direct the buyer of the relinquished property to issue the note in the name of the QI.

Example: If the relinquished property value is $100, the taxpayer might receive $50 in cash and a $50 note from the buyer. Fifty dollars in proceeds would be placed with the QI. The QI would also receive the $50 note from the buyer to be held along with the proceeds.

This method is typically used in those circumstances where the taxpayer wishes to use the note in the acquisition of the replacement property. In the context of the 1031 exchange, the buyer’s note is received directly by the QI and held throughout the exchange period so that the taxpayer does not have constructive receipt of the note, or any interest earned on the note, until the completion of the exchange transaction.

The taxpayer will then attempt to find a seller of replacement property who is willing to accept the note held by the QI as a portion of the purchase price for the replacement property. However, many sellers of replacement properties are reluctant to receive notes as payment and, therefore, it is often difficult for the taxpayer to accommodate this structure. If the note is not used to acquire replacement property, then the QI will distribute the note back to the taxpayer at the conclusion of the exchange and the note is then subject to taxable treatment.

How To Structure the §1031 Exchange to Avoid Taxpayer’s Receipt of the Installment Note

When faced with the possibility that the note may create unintended taxable consequences, the taxpayer will often look for ways in which to convert the note to exchange equity (i.e., cash) that can be used in the purchase of the replacement property as part of a §1031 exchange. [Note: The taxpayer should be aware that the debt offsetting rules for §1031 do not apply to the installment note. For purposes of the §1031 exchange, the note is treated as cash and is, therefore, not eligible for debt offset. As a result, the taxpayer cannot offset the receipt of the buyer’s note with corresponding debt on the replacement property.] Below are some alternative exchange structures to assist taxpayers in converting the note into exchange equity.

1. Intermediary Sells Note to Taxpayer for Full Value

The most common structure is one in which 1) the buyer’s note is originally made payable to the QI at the outset of the exchange transaction, and 2) the taxpayer would subsequently purchase the note from the QI with new cash.

The purchase of the note by the taxpayer takes place at the closing of the replacement property. This is done to avoid constructive receipt issues, which would arise if the QI held non-exchange proceeds during the exchange period. Therefore, mechanically at the closing of the replacement property there would be a substitution of cash for the value of the note, and the note would then be transferred to the taxpayer. The cash would then be combined with the other exchange proceeds to be used toward the purchase of the replacement property.

This solution is a product of the boot-offsetting rules, which state that new cash may be used in an exchange transaction to offset the cash boot received by the taxpayer in the form of the buyer’s note. This solution, however, does require that the taxpayer have available cash to purchase the note from the QI. Also, despite its reliance on basic §1031 rules, this structure has not been approved or disapproved by the IRS.

2. Taxpayer Loans Funds to Buyer Prior to Sale of

Relinquished Property

Another alternative requires the taxpayer to loan the buyer the proceeds necessary for the purchase of the relinquished property prior to the closing. The loan from the taxpayer to the buyer is secured at closing by a deed of trust on the relinquished property. The buyer then uses the proceeds from the loan to purchase the taxpayer’s relinquished property in an all-cash transaction. This alternative also requires that the taxpayer have cash available for purposes of the loan to the buyer.

This structure has not been approved or disapproved by the IRS, but it is potentially susceptible to attack as step transaction, in which the loan by the taxpayer could be re-characterized by the IRS as an installment note. In an effort to avoid this circumstance, the taxpayer may have a related or friendly party make the loan to the buyer. However, in that circumstance the taxpayer loses the option to treat the loan as an installment loan if taxpayer later fails to acquire replacement property.

Please note: There is limited favorable authority for this structure, which, although not directly on point, does support the basic structure of a pre-transaction loan to the buyer (Ltr Ru; 9826033; 200109022).

3. QI Could Sell the Note to a Third Party

As a final option, the taxpayer could direct the QI to sell the note to a third-party buyer and receive the proceeds from the sale of the note into the QI account. The proceeds would then be held by the QI for eventual use in the purchase of replacement property.

Unfortunately, this alternative carries with it some inherent difficulties. Primary among these difficulties is the fact that the note would necessarily have to be sold at a substantial discount, which would be much less than its face value. Also, the QI could be viewed as the agent of the taxpayer in transacting the sale of the note, thereby disqualifying the exchange transaction (see IRC §453B).

Derrick M. Tharpe is vice president–exchange specialist with Wachovia Exchange Services in Winston-Salem, North Carolina.


©2003 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.