Seller Financing 1031 Exchange strategy can result in a no-cash-required upgrade of your real estate investment property.
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 Replacement Property.
But the primary 1031 Exchange Rule requires that when you do that, the Fair Market Value of the property that you buy, your Replacement Property, must be equal to, or greater than, the Fair Market Value of the property that you sell, your Relinquished Property.
And the major secondary 1031 Exchange Rule states that you must use all of the money from the sale of the Relinquished Property, called your Net Sales Proceeds, in the purchase of your Replacement Property.
There are more Section 1031 Exchange rules, and you can read about them here.
SELLER FINANCING 1031 EXCHANGE
This can create a cash dilemma, a situation where you end up with, say, $200,000 in cash from the $300,000 sale of your Relinquished Property, with these funds being held by your Qualified Intermediary until you can Close on the purchase of your Replacement Property.
And this, in itself, is a good cash situation to be in.
But if you are looking at a $400,000 Replacement Property, that means that you are going to have to borrow at least $200,000 and go through the tedious loan process (with the 45-day and 180-day timelines running), and probably pay another $20-30,000 in associated loan and transaction cost.
And that is a bad situation to be in.
However, the answer to your problem could be a Seller Financing 1031 Exchange.
1031 EXCHANGE 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 get the Seller, from whom you are purchasing your Replacement Property, to take your $200,000 as a Down Payment, and then take back a note for the remaining $200,000.
It will depend on his personal situation, but if, like you, he is selling at a good profit after a few years, he can probably consider your offer. You could even offer to put a Balloon Payment clause in the note, paying it off after a certain number of years.
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 Closing costs of $20,000 you will have Net Sales Proceeds of $200,000.
1031 EXCHANGE REPLACEMENT PROPERTY
Let’s say you purchase a Replacement Property for $400,000.
You must use the $200,000 of Net Sales Proceeds toward the purchase of the property, leaving $200,000 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 $200,000.
Or you can do a seller financing 1031 Exchange.
You can give $200,000 of Net Sales Proceeds to the Seller as a Down Payment, and you can sign a note back to the Seller for $200,000, and do seller financing.
Or you can use any combination of the three.
And don’t believe the misinformation being repeated everywhere that you must incur debt on the purchase of your Replacement Property, and it must be equal to the amount of debt that you paid off when you sold your Relinquished Property. I even saw this on one of the Blogs of a major bank the other day.
It is not only incorrect, but it is total nonsense.
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.
I touch on this same concept in more than one of my books, but the one with the most detailed information is “Real Estate Investing Vocabulary Of Terms.” If you would like to preview it, you can go here on this website to look at the first one, use the 3D Flip Reader to look at the Contents and read the first few chapters.
The paperback is available on my Amazon Author Page, along with my other books.
And I have related Articles about real estate investing and other real estate matters from other perspectives on my LinkedIn Page.
I am also active on Quora.com where I have answered over 300 questions, and they have almost 3 Million views.
If you happen to be doing, or if you are considering doing, a Section 1031 Like Kind Exchange, then you should start with a Dictionary, and I have done one, in 3 separate Blog Posts here: Part 1, Part 2, and Part 3. And I have a lot of material for you to consider on my S1031 Exchange website.
You should always check out the credentials of anyone, like myself, who you are relying on for accurate information by looking closely at their Biography. Here’s mine.
If you would like to read one of my books, but are not sure which one to start with, here are four that I think you would enjoy.
DISCLAIMER: I am an Attorney licensed to practice in Texas, North Carolina, Virginia, and the District of Columbia. But I am not your Attorney. I would be honored if I were, but I am not. Reading this Blog does not created an attorney-client relationship between us. Internet content should not be used as a substitute for the advice of a competent Attorney admitted or authorized to practice law in your state or jurisdiction.