Installment Sales and the 1031 Exchange

Submitted by,
David Moore
Equity Advantage, Incorporated
Today’s economic environment may require the use of a contract sale. A common misunderstanding of installment sales is their impact on a tax-deferred exchange. Since a note typically represents equity in a property and a 1031 Exchange requires all equity to be carried forward to be completely tax deferred, it is necessary to use the note in the exchange for complete tax deferral.
In order for a note to be used in an exchange, you, the Exchangor, must not have had actual or constructive receipt of the note. The note must be the Facilitator’s at settlement just as any cash must be.
The following are options available to you:

1. As the Exchangor, you can direct Equity Advantage to sell the note to a third party such as a bank, pension fund manager or a private investor. The proceeds from the sale of the note are then deposited with Equity Advantage. You will need to deposit additional cash to offset the amount that was discounted on the note for total tax deferral. If the additional cash is not deposited, you will have tax exposure on the difference between the note’s value and the discounted sale price of the note if any.
2. You, the Exchangor, use the note along with the cash to acquire the replacement property. The Seller of the replacement property now owns the note.
3. You, the Exchangor, purchase the note from Equity Advantage. The note has now been converted to cash and the exchange can be completed.
4. If the note is short term and matures inside the 180-day exchange period, it is possible to complete the exchange after the note is paid off.
5. Finally, if you are not concerned with deferring all of your taxes, you may choose a partial exchange, using only the cash proceeds in the exchange. The note will be considered “boot” and payments will receive installment sale treatment (Section 453). Depreciation recapture is due in the year the sale occurred.
Equity Advantage often receives requests to structure an exchange for a potential client that is about to receive a balloon payoff of a note they have been in receipt of. Unfortunately the taxpayor has had receipt of the note and therefore a future balloon payment will be fully taxable.
Understanding the motivation behind the sale and the use of the note often dictates the option chosen. A careful review of the options available and their tax consequences is critical, the taxpayor’s tax and legal counsel will be able to make the right decision given time and information.
David Moore
Equity Advantage, Incorporated
One Centerpointe Drive, Suite 300
Lake Oswego, Oregon 97035 Phone (503) 598-1031
(800) 735-1031 Fax (503) 619-0226 http://www.1031exchange.com
Tax Advice Notice: The above written material is general information and not tax advice. Please consult with your CPA and/or attorney for tax advice. Per IRS Circular 230 Disclosure, IRS regulations requires us to notify you that this communication was not intended or written to be used, by you as the taxpayer, for the purpose of avoiding penalties that the IRS might impose on you.