A taxpayer's CPA called last week and said he had a problem. His taxpayer wanted to sell its investment property---but the only way it could be sold is if the taxpayer took back financing towards the purchase price.
Most of my bloggers are aware that if the taxpayer takes back financing, they are taxed on that financing as they receive the principal and interest payments. In IRS jargon, this is called an installment sale. That means that in order to have a complete tax deferred Section 1031 exchange, the taxpayer must use all of the proceeds toward the purchase of the replacement property. If the taxpayer takes back financing, it's as if they received all of the financed funds and therefore they are taxed as they received them--that means they have not tax deferred those financed funds.
Let's use an example. Brian sells an investment property to Sam for the sales price of $100. Brian originally purchased the property for $15. This leaves a profit of $85 for Brian. Brian will be given $60 at closing and has been asked to take back financing in the amount of $40. That means Brian will be able to do a tax deferred exchange on $60 ($100 - $40 = $60) and will take back a loan to himself in the amount of $40, which will be taxed to him as payments are received. This is called a partial exchange, as part of the transaction qualifies and is tax deferred and the other part does not qualify and is taxed. I know you are asking yourselves: is there a solution to this scenario?
YES THERE IS !! There are 3 parts to the solution:
#1) The $40 that Brian took back in seller financing must be initially placed with the Qualified Intermediary;
#2) The financing must be paid off prior to the taxpayer obtaining its replacement property; and
(3) Once the Qualified Intermediary(QI) receives all of the funds (the amount that was paid off from the financing and the other funds paid at closing), the QI closes on the replacement property, using all of the funds (the amount that was paid off from the financing and the other funds paid at closing), Note: The taxpayer never received or touched any of the funds. Once the taxpayer, in a timely fashion, purchases and closes on an investment property of equal or more value than what they relinquished, a valid tax deferred exchange occurs. See--that wasn't so hard to solve.
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