Can You Do a 1031 Exchange With Owner Financing?

Combining a 1031 exchange with owner financing is possible, but the transaction requires careful structuring to achieve a full tax deferral. A 1031 exchange allows an investor to defer capital gains taxes on a property’s sale by reinvesting the proceeds into a “like-kind” property. Owner financing involves the seller acting as the lender for the buyer, accepting a promissory note for part of the purchase price instead of receiving the full amount in cash.

The primary challenge is that IRS regulations treat a seller-financed note as non-like-kind property. If the seller directly receives the note, its value is considered taxable. With specific strategies, an investor can incorporate a seller-financed note into an exchange and defer the entire capital gains tax liability.

Key Concepts in an Owner-Financed Exchange

The central issue in combining owner financing with a 1031 exchange is the concept of “boot.” In this context, boot is any property received by the seller that is not like-kind real estate, such as a promissory note. A seller-financed note is a formal document outlining the loan amount, interest rate, and repayment schedule. Under IRS rules, receiving boot makes the exchange partially or fully taxable to the extent of the boot’s value, and a seller-financed note received directly is considered boot.

To avoid what the IRS calls “constructive receipt,” the exchanger cannot have control over or access to the sale funds or the note. This is where the role of a Qualified Intermediary (QI) is important. A QI is a neutral third party that facilitates the exchange by holding the sale proceeds from the relinquished property. The QI must receive and hold both the cash proceeds and the seller-financed note to preserve the tax-deferred exchange.

Structuring Options for Full Tax Deferral

Use the Note to Acquire the Replacement Property

One strategy for a complete tax deferral is to have the Qualified Intermediary (QI) use the seller-financed note as part of the payment for the replacement property. In this scenario, the note from the buyer of the relinquished property is made payable to the QI. During the 180-day exchange period, the QI can assign or trade this note to the seller of the desired replacement property as a portion of the purchase price. The primary difficulty with this approach is finding a replacement property seller who is willing to accept a third-party promissory note instead of cash, making this a less common option.

Sell the Note to a Third Party

Another method is for the QI to sell the promissory note to a third party for cash during the exchange period. The note is initially made payable to the QI, who then seeks out a buyer, which could be a private investor or a financial institution. Once sold, the cash proceeds are deposited into the exchange account held by the QI. These funds are then combined with the initial cash from the property sale and used to acquire the replacement property. A consideration here is that the note may have to be sold at a discount, and if so, the exchanger may need to add personal funds to the exchange to acquire a replacement property of equal or greater value.

The Exchanger Purchases the Note

A common strategy involves the exchanger purchasing the note from their own exchange. The process begins with the note from the relinquished property’s buyer being made payable to the QI. The exchanger then uses personal funds—money from outside the 1031 exchange—to buy the note from the QI at its full face value. This action converts the note held by the QI into cash within the exchange account, allowing for a complete tax deferral. The exchanger personally takes ownership of the note and will collect payments, and since the note was bought at face value, principal payments are a tax-free return of capital, though interest remains taxable.

Combining the Exchange with an Installment Sale

When the strategies for a full tax deferral are not possible and the seller-financed note remains with the Qualified Intermediary (QI) at the end of the 180-day exchange period, the transaction can be treated as a combination of a 1031 exchange and an installment sale under Internal Revenue Code Section 453. This allows the tax on the gain associated with the note to be paid over time as principal payments are received, rather than all at once.

Under this structure, the cash portion of the sale is used in the 1031 exchange to defer gain, while the note is treated as boot. The tax on this boot is reported using the installment method, where the gain is recognized proportionally as each principal payment on the note is received. This coordination is permitted under Treasury Regulation §1.1031(k)-1.

For example, assume an investor sells a property for $1 million with an $800,000 gain. The buyer pays $700,000 in cash and provides a $300,000 seller-financed note. The investor uses the $700,000 cash to acquire a replacement property in a 1031 exchange. The $300,000 note is considered boot, but its tax liability is deferred under the installment sale rules.

To calculate the tax, the gross profit percentage on the note must be determined. The contract price for the installment sale is $300,000 (the value of the note), and the recognized gain to be reported is also $300,000. In this simplified case, the gross profit percentage is 100%. This means every dollar of principal received on the note is taxable gain.