What is the problem with seller financed properties that can affect a 1031 exchange?
The amount of money, in the form of a note, that the seller is asked to “carry back” for the buyer could be taxable as capital gains. This amount of money is called “boot” by the IRS.
So let’s say you sell a commercial income property for $575,000 to a buyer using seller financing. If the buyer comes up with $500,000, but asks you to carry back $75,000, that is money that you haven’t paid for. You have only a promissory note agreeing to pay that amount over a period of time.
So the question then becomes:
“If the total amount of money excluding the note is now less than the value of the property you sold, are you still eligible for a 1031 exchange?
And if you are still eligible for a 1031 exchange, does that note – and the amount it represents- get covered under the 1031 exchange rules, since you haven’t yet received the money?
The unfortunate news is that you do have to pay taxes on the entire amount of the note. The even more unfortunate news is that depreciation recapture will also apply.
In order to understand what depreciation recapture means, let’s use an example. Let’s say you bought a real estate investment property in 2002 for $700,000. In 2012 you decided to sell it, and you got $800,000 for it.
You might look at those numbers and assume that your profit of $100,000 is subject to a capital gains tax of 15%, since you held the property for more than a year. You would then owe 15% on $100,000, which comes out to $15,000.
The bad news is that the taxable amount is a lot higher, and here’s why. Remember all of those years when you got off on your taxes by deducting the amount of property depreciation? Well, you weren’t really getting off – those taxes were just being frozen. They come due when you sell the property.
But there’s more bad news.
Contrary to popular opinion, not all of your long-term capital gains are taxed at 15%. No, that would be far too simple. So in addition to the 15% rate, there is a 20% rate for upper-income investors and there are several additional long-term capital-gains rates, which can range from 0% to 28%.
Last but not least, there’s potentially a 3.8% Medicare surtax on capital gains reaped by upper-income investors. Which category your profit will fall into depends on your income-tax bracket, the type of asset you sold, how long you held it and when you sold it. Keep in mind, short-term gains (on assets held for one year or less) are taxed at your ordinary income rate, which can range from 10% to 39.6%.
There is a bit of light at the end of the tunnel. Hopefully you have a great accountant, and your great accountant remembered that when you bought the commercial property, you were paying for both the building and the land it rests on.
And since only the building itself, and not the land it rests on, is subject to property depreciation, then amount of money that goes towards depreciation recapture should be less. Of course you paid that amount when you paid your yearly income taxes, but at least you don’t have to pay it now.
So. Back to your seller-financed 1031 exchange…
So let’s say you’ve got a buyer who buys your property for $800,000. They give you 10% as a down payment, and are able to get 70% from a private lender. That leaves another 10%, or $80,000, that goes towards their seller-financed mortgage.
If you claimed $60,000 over the period that you owned the commercial income property as your property depreciation, then $60,000 of the total $80,000 is taxed at a rate of 25%, and the other $20,000 is taxed at the regular capital gains tax rate of 15%. And one more thing…. the entire $80,000 is subject to state taxes.
So $23,000 of your profit is already gone even before you take off for state taxes.
What you should do instead?
In order to get around this problem – and because you really want to sell this property to this buyer, you can do one of two things.
The simplest thing to do would be simply to cover the difference that they buyer is asking for yourself, with CASH. That way, you could show the IRS that 100% of the money of the sale was used for the purchase of the replacement property. The buyer would then give you a second note, and a second mortgage.
The other option is to make the note payable to the 1031 intermediary. Then the note is held until a replacement property is ready to be purchased. At that point, you, the seller, or a family member or friend, will buy the note from the intermediary’s 1031 exchange account.
At that point, anything that is paid on that amount is free of capital gains taxes and depreciation recapture taxes.