1031 Exchange With Seller Financing: Can You Carry a Note and Still Defer?
Buyers in a tight credit market ask sellers to carry paper. Sellers doing an exchange then ask me whether the note blows up the deferral. It doesn't have to, but a note made payable to you is cash in the IRS's eyes. Here's how to structure it so most of the gain still defers.
- A note from your buyer payable to you is boot: taxable gain to the extent of the note's face value, reported on the installment method as payments arrive.
- The standard fix is to make the note payable to the qualified intermediary, so it's part of the exchange proceeds rather than something you received.
- The QI can then get cash from the note (buyer pays it off, you buy it, or it's sold) within the 180 days so the full amount reinvests.
- Seller financing on the property you're buying is just debt and creates no boot problem at all.
Why a note is boot
Section 1031 defers gain only to the extent you receive like-kind property. A promissory note is not real estate; it's an obligation, and Treas. Reg. §1.1031(k)-1(f) treats a note payable to you as property received at closing. If you sell for $1,000,000 and take a $300,000 note, you have $300,000 of boot. The exchange doesn't fail, but $300,000 of gain is recognized (taxed under the installment method as principal comes in, with the recapture portion first). Everything reinvested through the QI still defers. How boot is computed.
Structure 1: Make the QI the payee
Have the note and deed of trust name the qualified intermediary, not you, as lender. Now the note is part of the exchange funds the QI holds, not something you received. The buyer makes payments to the QI. The catch is that the QI needs cash to buy your replacement property by day 180, and a 30-year note doesn't produce that. So structure 1 is always paired with one of the next three.
Structure 2: Buyer pays off the note within 180 days
If the buyer is bridging a short gap (waiting on a loan, a 1031 of their own, or a property sale) and can pay the note in full before your day 180, the QI simply receives the cash and uses it for the replacement. Clean, common, and only works when the buyer's timeline is genuinely short.
Structure 3: You buy the note from the QI
Using outside cash (savings, a line of credit, a loan against another property), you purchase the note from the QI at face value. The QI now holds $300,000 of cash to complete the exchange, and you hold the note in your own name as an ordinary investment: interest is ordinary income, principal comes back tax-free because you paid full basis for it. This is the most flexible approach for sellers who have liquidity elsewhere. It preserves 100% of the deferral.
Structure 4: Sell the note to a third party
The QI sells the note to a note buyer, usually at a discount that depends on the rate, term, and the borrower's credit. The QI receives the cash and completes the exchange. The discount is a real cost, but on a note with a healthy rate and a solid buyer it may be small. Arrange the note buyer before the sale closes so the terms are written to be sellable.
Structure 5: Accept the boot and use the installment method
Sometimes the simplest answer is right. Take the note in your own name, exchange the cash portion through the QI, and report the note's gain under §453 as you're paid. You defer most of the gain through the exchange and spread the rest over the life of the note. The comparison between spreading and deferring is in installment sale vs 1031 exchange.
Seller financing on the replacement side
If the seller of your replacement property carries a note for you, that's debt you're taking on, exactly like a bank mortgage. It counts toward the equal-or-greater-debt requirement and creates no boot. Seller financing on the buy side is often the easiest way to satisfy the debt-replacement test when bank underwriting is slow.
Frequently asked questions
Can I do a 1031 exchange if I'm providing seller financing?
Yes. Make the note payable to the qualified intermediary so it's part of the exchange proceeds, then convert it to cash within 180 days by having the buyer pay it off, buying it yourself, or selling it. A note payable to you personally is taxable boot.
Is a seller-carried note taxable in a 1031 exchange?
If it's payable to you, yes, as boot up to the note's face value, taxed on the installment method as principal is received. If it's payable to the QI and converted to cash for the replacement purchase, no gain is recognized.
Can I buy the note from my qualified intermediary?
Yes. Purchasing the note at face value with outside funds gives the QI cash to complete the exchange and leaves you holding the note as a fully-basis investment with no deferred gain in it.
Does seller financing on the property I'm buying cause boot?
No. Debt you take on to acquire replacement property, whether from a bank or the seller, counts toward the debt-replacement requirement and creates no boot.
Buyer wants you to carry paper?
The note has to be drafted correctly before closing. Let's structure it while the contract is still negotiable.
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