|
Sellers are sometimes asked to provide financing to buyers as part of their property sale negotiations. This arrangement, commonly known as seller financing, typically involves payments spread out over several years. Under Section 453 of the Tax Code, this can be reported as an installment sale, allowing sellers to defer the recognition of gains over the life of the note.
The installment sale method provides sellers with a flexible tax strategy. Taxes are paid annually based on the payments received, with each payment split into:
- A return of your basis,
- Capital gains taxed at applicable rates, and
- Interest income taxed as ordinary income.
But how does this strategy work in the context of a 1031 exchange, where the goal is to defer all capital gains taxes by reinvesting the proceeds into like-kind replacement property? While combining these two tax-deferral tools creates some challenges, the IRS provides guidance under Section 453(f)(6) to navigate these complexities. With careful planning, there are several ways to make seller financing work in a 1031 exchange while preserving tax deferral.
Challenges of Seller Financing in a 1031 Exchange
When completing a 1031 exchange, providing seller financing to the buyer of the relinquished property presents a key issue: receiving anything other than like-kind property (such as a promissory note) is taxable as "boot." However, there are strategies to address this challenge while keeping your exchange intact.
| 
