1031 Information Center™

Taxpayers are always looking for tax saving opportunities when selling appreciated property. That's why the deferred exchange is so popular with smart real estate investors and professionals. It permits them to sell property and buy Replacement Property without recognizing taxable capital gains. However, if they “exchange down”, boot taken back to balance the equities is taxable. And it’s taxable right now. This makes everyone except the IRS very unhappy.

Fortunately there is an ingenious tax strategy that permits you to take back boot in a §1031 exchange without paying tax on it now. Gain from the boot can be deferred into future tax years. It's done by taking back a purchase money installment note from the “buyer” of the Relinquished Property to balance all or part of the equities. When structured correctly, the taxable gain in the note may be reported using the installment method of tax accounting.

If you are an exchange specialist, be sure to tell your clients about this marvelous tax saving strategy. They will love you for it—all the way to the bank.

If your sale or exchange involves both like-kind property and boot in the form of an installment sale note, the rules of both §1031 and §453 (dealing with installment sales) apply. Under §1031, no gain will be recognized on the like-kind property involved. However, the installment sale note is boot and gain is recognized on the net boot received.

Under the installment sale rules of §453, fair market value of like-kind property received is not recognized as part of the Contract Price or as payment in the “year of sale.” This results in a Gross Profit limited to the installment note and any other boot received. (To keep life simpler, let’s assume no other boot.) The outcome is the Contract Price and Gross Profit are the same amount.

Figuring the Installment Sale Percentage (Gross Profit Percentage) is easy. Since the two amounts are equal, the Installment Sale Percentage is 100%. Now comes the best part.

Since you have entered into an exchange and traded down, taking back an installment note to balance the equities, you enjoy the benefits of both the exchange and installment sale rules. Under §1031 rules, your recognized gain is limited to the installment note taken back as boot. And under §453 installment sale rules, you are permitted to report this gain using the installment method of tax accounting and report the gain ratably over the time you collect it from the buyer.

The result is you have made a real estate exchange, traded down, taken back an installment note to balance the equities and recognize little or no gain in the year of the exchange.

When an exchange results in the creation of a purchase money installment note, both exchange and installment rules apply. First, §1031 kicks in and limits the recognized gain to the fair market value of the net boot received. (This is a mandatory rule—not elective.) After the recognized gain is figured under §1031, the installment rules under §453 are applied. Installment sale rules are elective—you may elect-out if you desire.

Your installment sale Contract Price does not include the fair market value of the like-kind property you receive in the exchange. Therefore, like-kind property you receive in the exchange is not treated as payment received.

Your installment sale Gross Profit (recognized gain) is reduced by gain not recognized in the exchange.

âCaution : Using the installment method of tax reporting is elective—not mandatory. It’s your choice. You can recognize all the gain in the year of the exchange if you want depending on your other income and losses during the year of the exchange. For example, if you had large capital losses during the year, you might elect to recognize the entire gain and offset it against the capital losses. Your call.

Here is a parallel point to illustrate the structure of an exchange combined with an installment note.

Parallel Point 7-1

You own a parcel of land with a fair market value of $100,000. The property is free and clear and your installment sale basis is $30,000. If you make a cash sale you will be taxed on the recognized capital gain of $70,000. You decide instead to make a §1031 exchange and avoid payment of the tax.

You find a choice Replacement Property. Even though its fair market value is only $80,000, it’s exactly the property you want. You agree to exchange your parcel for the $80,000 parcel and take back an installment note for $20,000 to balance the equities. You receive no payments in the “year of sale.”

The transaction falls under the rules of §1031 exchanges. This rule is mandatory, not an election, and requires no gain or loss be recognized on that part of the transaction involving like-kind property. This rule applies first and limits your Gross Profit on the sale to $20,000—the amount of boot taken back in your exchange.

Now the rules of §453 installment sales kick in. Your Contract Price is only $20,000—the installment note you received. The $80,000 parcel of like-kind property you received is not treated as part of your Contract Price.

Your Gross Profit Percentage is 100%—$20,000 Gross Profit divided by your Contract Price of $20,000. Since you did not collect any payments in the “year of sale”, you have no recognized gain in the year of your exchange.

The IRS issued Treasury Decision 8535, coordinating the safe harbor rules of deferred exchanges with installment sale rules. These rules provide, for installment sale purposes only, that determination of whether payment has been received in the year of sale or not will be made without regard to the fact that qualified escrow accounts, qualified trusts, or Qualified Intermediaries have been used. They are disregarded for installment sale purposes until the earlier of

the time the safe harbor would otherwise cease to apply for purposes of the deferred exchange, or

end of the exchange period.

âTranslation: If you use the deferred exchange safe harbors, you will not be treated as having constructive receipt of installment payments. The gain in the installment note will not be triggered.

Subject to other requirements of the installment sale rules (§453 and §453A and related Regs), if you use safe harbors of the deferred exchange regulations, you are entitled to report gain recognized from an installment note (taken back in a deferred exchange) under the installment method of tax reporting.

The rules also apply to a transaction that ultimately fails to qualify as a like-kind exchange under §1031. This is called a “ failed exchange.” The Regs provide a person who otherwise satisfies the definition of a Qualified Intermediary is treated as a Qualified Intermediary (and not your agent) even if that person ultimately fails to acquire Replacement Property and transfer it to you. The Regs only apply, however, if:

at the beginning of the exchange period, you had a bona fide intent to enter into a deferred exchange, and,

the Relinquished Property was eligible for like-kind treatment under §1031.

Other than receiving payments of principal and interest on the note during the time your deferred §1031 Exchange Time Period, there are three things that can happen:

1.The Qualified Intermediary, as part of the final accounting, distributes the note to you when the exchange is successfully closed. Or when the exchange fails.

Treatment: The note retains its identity as an installment note in your hands. Gain is not triggered. You recognize gain only as the note is paid off under the regular installment sale rules.

2. Following your instructions, the Qualified Intermediary sells the note during the Exchange Time Period.

Treatment: Taxwise, nothing happens. No gain is triggered. The note is simply converted into cash. Your net boot received—if any—is the measure of any gain recognized after the exchange is closed and final accounting is made. Look at it this way: If you had sold the Relinquished Property for cash under your exchange agreement with your Qualified Intermediary, the amount of cash received does not trigger gain. Neither does a sale where both cash and an installment note are received. Since the note was sold “inside” the Exchange Time Period, the cash received does not trigger gain. When the Exchange Time Period ends and the exchange is closed, the net boot you receive figured at that time is the measure of your recognized gain.

3. Following your instructions, the Qualified Intermediary uses the note during the Exchange Time Period as part of the consideration to acquire the Replacement Property.

Treatment: No gain is triggered.

One strict requirement of installment sale rules is the seller must receive the installment note from the buyer. Receipt of the note from anyone else is treated as payment in the year of sale. What happens in a §1031 deferred exchange if the note is acquired from a person other that the person acquiring your Relinquished Property?

Addressing this problem, the Regulations provide a special rule: For installment sale purposes, the receipt by you of an installment note made by Qualified Intermediary's transferee is treated as receipt of indebtedness of the person acquiring your Relinquished Property. Receipt of the installment note will not be considered payment under §453.

The Treasury and the IRS believe this treatment is appropriate because generally the transferee is, in substance, the person who acquires the Relinquished Property. The Qualified Intermediary serves only to facilitate the acquisition. This means you can qualify to report installment gain recognized in a deferred exchange using the installment method if you use the deferred exchange safe harbors.

IRS Illustrations

Here are four illustrations taken from the Regs to help you put together your deals.

IRS Illustration 1

On September 23, 1993, you enter into an exchange agreement with Buyer. Buyer deposits $100,000 in a qualified escrow account meeting all the safe harbor requirements. On March 11, 1994, Buyer acquires Replacement Property with a fair market value of $75,000 and delivers it to you. At that time you take the $25,000 cash left in the escrow account to balance the equities.

IRS Illustration 2

Buyer offers to buy the property but is unwilling to participate in a like-kind exchange so you enter into an exchange agreement with EZ-Exchange, a Qualified Intermediary. On September 22, 1993, you transfer the Relinquished Property to EZ-Exchange who transfers it to Buyer for $100,000 in cash. On March 11, 1994, EZ-Exchange acquires Replacement Property with a fair market value of $75,000. He delivers it to you along with the balance of $25,000.

IRS Illustration -3

Buyer offers to buy the property but is unwilling to participate in a like-kind exchange so you enter into an exchange agreement with EZ-Exchange, a Qualified Intermediary. On September 22, 1993, you transfer the Relinquished Property to EZ-Exchange who transfers it to Buyer for $80,000 in cash and Buyer's 10-year installment note for $20,000. On March 11, 1994, EZ-Exchange acquires Replacement Property with a fair market value of $75,000. He delivers it to you along with the installment note of $20,000 and the $5,000 cash balance.

IRS Illustration 4

Buyer offers to buy the property but is unwilling to participate in a like-kind exchange so you enter into an exchange agreement with EZ-Exchange, a Qualified Intermediary. On December 1, 1993, you transfer the Relinquished Property to EZ-Exchange to facilitate an exchange. EZ-Exchange transfers it to Buyer for $100,000 in cash. Although you have a bona-fide intent to enter into a deferred exchange at the beginning of the exchange period, you do not identify or acquire any Replacement Property. At the end of the 45-day identification period in 1994, EZ-Exchange delivers to you the entire $100,000 from the sale of the property to Buyer.