Exchanges & Installment Sales

Taxpayer Able, who is a non-dealer in real estate, owns improved rental property with an adjusted cost basis of $100,000. Able has just received a bona fide offer to sell his property for $750,000. Pursuant to the terms of the offer, the buyer will pay Able cash in the amount of $600,000 subject to Able agreeing to take back a purchase money second mortgage in the amount of $150,000 payable over ten years at a market rate of interest as full consideration for the balance of the purchase price.

Able agrees to the price and terms of the offer, subject to his right to transfer the property to a Qualified Intermediary of his choice prior to the date of closing so that the sale can be concluded in a manner that qualifies Able for favorable tax treatment under §1031 of the Internal Revenue Code, (“IRC”).

What are Able's choices with regards to the $150,000 purchase money mortgage?

1. Able elects to receive the note which is made payable to Able by the buyer at the time of sale.  Able's receipt of the buyer's note and mortgage is treated as cash boot received by Able in the tax year of the sale and taxable to Able under the installment sale provisions as payments are received.

Assume Able acquires qualifying replacement property with a fair market value of $600,000 and receives no additional boot in the Exchange. Able realizes gain in the amount of $650,000. He recognizes gain in the tax year of the sale to the extent of net boot received in the Exchange in the form of the $150,000 purchase money mortgage. His basis in the note is zero. Able will report taxable income from the sale of property held for the productive use in a trade or business in the amount of 100% of the principal payments received in each tax year.

2. The buyer’s note is made payable to the Qualified Intermediary at the time of sale and assigned to Able following the termination of the Exchange.  The Qualified Intermediary receives all payments of principal and interest under the note from the buyer and holds all amounts in the Exchange escrow.  Able's receipt of the note from the Qualified Intermediary at the termination of the Exchange is considered to be receipt by Able of the note of the buyer and qualifies for treatment under the installment sale provisions. Able’s basis in the note is zero.

Assume Able acquires replacement property with a fair market value of $600,000 and that the payments received by the Qualified Intermediary are transferred to Able along with the assignment of the note following the termination of the Exchange. Able will treat the payments received from the Intermediary as well as subsequent payments received from the buyer under the installment sale provisions. If the termination of the exchange occurs in the tax year following the tax year of the sale (tax year of the initial transfer date) then Able will have no tax liability in the year of sale.

3. The buyer’s note is made payable to the Qualified Intermediary at the time of sale. The Intermediary sells the note to a third party buyer for cash at a discount and holds the cash in the Exchange escrow for the purchase of qualifying replacement property.

The Intermediary has converted the note to cash and added the cash to the Exchange escrow. If all of the cash escrow is spent on the acquisition of qualifying replacement propertythen Able’s Exchange will be 100% tax deferred. Able will not be in receipt of any non-like kind property at the termination of the Exchange. The amount of the discount should be treated as a transaction cost thereby reducing the fair market value of replacement property Able is required to receive in the Exchange.

4.  The buyer’s note is made payable to the Qualified Intermediary at the time of sale. The Intermediary sells the note to Able for cash in the amount of the face value and holds the cash in the Exchange escrow for the purchase of qualifying replacement property.

This option sounds to good to be true. Able can purchase the note from the Intermediary for $150,000. The Intermediary is then holding $750,000 cash in the Exchange escrow and uses the full amount to purchase replacement property. Able receives no boot in the Exchange and therefore, does not recognize any gain. In addition, Able's basis in the note is the $150,000 he paid the Intermediary to purchase the note. Able will not pay tax on the principal portion of the installment sale payments as they are received.

However, Able may be considered to be in receipt of non-like kind property held by the Intermediary prior to the receipt of qualifying replacement property. Consequently the constructive receipt provisions of Reg. §1.1031(k)-1(g)(6) may have been violated and the Exchange nullified with respect to non-recognition treatment. Able may be subject to tax on the entire amount of realized gain of $650,000. If Able desires the benefits of this option he should conduct the Exchange in the form of option 5 below.

5. The buyer’s note is made payable to the Qualified Intermediary. Able also funds the Exchange escrow with cash boot given in the amount of $150,000. At the termination of the exchange the Qualified Intermediary assigns the note to Able.

This option will accomplish the same results as option 4 without placing Able in the position of being in constructive receipt of funds held by the Intermediary. Able's cash boot paid in the amount of $150,000 to the exchange escrow offsets Able's receipt of $150,000 boot in the form of the note assigned by the Intermediary to Able at the termination of the Exchange. Able receives no net taxable boot in the Exchange, his basis in the note is $150,000 and there is no tax liability on Able's future receipt of principal payments made pursuant to the note. 

6. The buyer’s note is made payable to the Qualified Intermediary at the time of sale. The Intermediary uses the note at face value or at a discount as partial consideration for the purchase of qualifying replacement property.

Able locates qualifying replacement property with a fair market value of $700,000. He negotiates an agreement with the seller to pay $600,000 cash and the balance by assignment of the note, at discount. Able assigns his agreement with the seller to the Intermediary who acquires the property from the seller in accordance with the terms of the agreement. To conclude the Exchange, the Intermediary transfers title to Able. There are no funds remaining in the Exchange escrow and the note has been fully spent on the acquisition of replacement property.

Able’s Exchange is fully tax deferred. Able receives no boot in the Exchange. The $50,000 discount of the note is treated by Able as Exchange transaction costs and offsets the reduction in value of the replacement property. Able has deferred the potential gain associated with the receipt of the note from the relinquished property buyer.

7. The buyer’s note is made payable to the Qualified Intermediary at the time of sale. Able's Exchange fails by virtue of the fact that Able is unable to identify qualifying replacement property before the expiration of the identification period or Able is not in receipt of qualifying replacement property prior to the termination of the Exchange period.

At the time the Exchange is terminated either by virtue of the fact that Able is unable to identify qualifying replacement property prior to the end of the identification period or because he is not in receipt of qualifying replacement property by the end of the Exchange period, the Intermediary will assign the note to Able and turn over the cash held in the Exchange escrow. Able will be in receipt of boot in the full amount of $750,000 and will be subject to tax on the lesser of the net boot received or the realized gain, ie. $650,000.

However, pursuant to Reg. §1.1031(k)-1(j)(2), Able is considered to be in receipt of taxable income on the date of such termination, not the initial transfer date, if: 1) Able had a bona-fide intent to Exchange on the initial transfer date; 2) Able and the Qualified Intermediary entered into a bona-fide Exchange agreement; and 3) the relinquished property is qualifying property, property held by Able for the productive use in a trade or business or for investment.