Sec 1031 Carry Back Notes

February 17, 2020

Awhile back, we discussed the partnership installment note method in partnership 1031 exchanges. As you may recall, this method was basically an exit strategy so that partnerships could buy out an exiting partner with optimal tax treatment. In this post, we will discuss another note which turns up even more frequently in 1031 exchanges: Sec 1031 carry back notes. Carry back notes are a common strategy by sellers who wish to take an installment sale offer from a certain buyer.

Multiple Reasons to Use Sec 1031 Carry Back Notes

There can be many reasons why utilizing this strategy may be a good idea. Not all buyers have enough cash to cover the full cost of a given property. In some cases, sellers may offer seller financing in with the use of a note in place of cash in order to finalize a transaction. Sec 1031 carry back notes represent the financial obligation of the buyer to deliver the remaining purchase price. In the context of Sec 1031, handling this note can be a tricky issue. 

Four Ways to Handle Sec 1031 Carry Back Notes

We will go over the various ways in which sellers may deal with a carry back note. As we will see, there is a total of four ways such notes can be handled. The circumstances of a case will determine which way is best. Then, we will discuss the potential tax consequences of these notes. The tax treatment of carry back notes follows the same logic which applies to all funds within the context of 1031. If you’ll conduct a transaction in which Sec 1031 carry back notes are used, it’s best to consult with a tax attorney. Consulting with a 1031 tax attorney will ensure that you’re aware of all contingencies. This is important, because not every qualified intermediary knows how to handle these types of cases. 

Place the Note Inside the Exchange

If a seller accepts a carry back note in lieu of full payment, this note can be handled in one of four ways. The note will be placed “inside” the exchange once the seller accepts. Once accepted, the seller can choose to buy the note from the exchange. In other words, the seller can replace the note in the exchange with cash. This is a very convenient method of handling Sec 1031 carry back notes, but obviously not one which is available in every case. The seller has to have sufficient funds available to make this possible.

Potential Open Market Sale

The seller can also choose to sell the note on the open market. Some outside parties may be willing to take assignment of the note as it represents a promise of future payment. However, this is typically only happens at a considerable discount. Usually, notes sold on the open market sell for 15% to 30% less than face value.  

Assist with Acquisition of Replacement

The seller may also choose to use Sec 1031 carry back notes as payment toward the acquisition of replacement property. In other words, the seller might convince the owner of replacement property to accept the note. This might be difficult to achieve, but very helpful to the seller. This allows the seller to acquire a replacement property of sufficient value with less complexity. The fourth option for handling the note is to simply allow the note itself to mature within the exchange timeline. As we know, sellers have a 180 day exchange period from the time of the sale to the purchase of the replacement property to complete the exchange. Depending on the situation, a buyer may give a note which will mature within that time period. In such a case, the seller may have the opportunity to allow the note to mature and acquire replacement property afterward.  

Choose What’s Best For You

These are the four methods for dealing with the note. In most cases, sellers won’t be able to choose from all four, but will have to select the best option available to them. In some cases, a seller may only have one option. Whatever the case may be, sellers should select the option which places them in the best financial position. Selling the note on the open market may avoid taxable boot, but it will cause the seller to have less money available for replacement property.  

Potential Tax Consequences of Carry Back Notes 

As long as Sec 1031 carry back notes are handled within the exchange, the seller will not incur a tax liability on the promissory note. Taxpayers only incur tax liabilities from 1031 exchanges when they receive boot (or have a failed exchange). This boot can take different forms, but it always involves receiving a benefit outside of the exchange, often cash proceeds.

Deal With the Note in the Time Allotted

If a seller takes the note from the exchange, payments received on it are taxable to the extent of gain. For instance, suppose a seller disposes of a property for $1.2 million, but takes a $200,000 note. If the seller decides to spend all the cash in the exchange and takes the note with him, he will ultimately be taxed on the $200,000 (if there’s capital gain). The key is to deal with the note entirely in the time period allotted by the exchange to avoid boot

Call Us For Assistance

Again, Sec 1031 carry back notes can be tricky. Taxpayers should consult with an experienced tax attorney in order to properly navigate these situations. At Mackay, Caswell & Callahan, P.C., we take pride in our advanced understanding of 1031 exchanges. We know that these real estate exchanges can result in the deferral of huge tax liabilities. Handling ta tax deferred exchange carefully is of the utmost importance to avoid any unnecessary complication or failure. If you have questions relating to exchanges or other topics related to federal taxes, don’t hesitate to reach out. Contact one of our top New York City tax attorneys today and we will respond to your inquiry immediately. 

Image credit: Creditdebitpro 

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