In tax-deferred exchanges, as in other real estate transactions, sellers sometimes are compelled to carry back financing as part of the transaction. This article will explore the different ways in which seller carryback notes may be utilized and the practical problems and tax consequences of their use.

       Terminology

                 It is important at the outset to clarify the terminology which will be used in this article. The "Exchangor" is the person seeking to dispose of one property and acquire another in a tax-deferred exchange. The "Relinquished Property" is the property which the Exchangor is disposing of and the "Replacement Property" is the property which the Exchangor is acquiring in the exchange. The "Buyer" is the buyer of the Relinquished Property and the "Seller" is the seller of the Replacement Property. The "Intermediary" is the person or entity which acquires and transfers both the Relinquished Property and the Replacement Property in the exchange.  

                The "First Escrow" is the escrow in which the Relinquished Property is transferred by the Exchangor to the Intermediary and by the Intermediary to the Buyer. The "Second Escrow" is the escrow in which the Replacement Property is transferred by the Seller to the Intermediary and by the Intermediary to the Exchangor.  

                The "Buyer's Note" is a seller carryback note executed by the Buyer in the First Escrow as part of the consideration for the acquisition of the Relinquished Property. The "Exchangor's Note" is a note executed by the Exchangor as part of the consideration for the acquisition of the Replacement Property. 

Use of a Buyer's Note in an Exchange 

                The most common use of a seller carryback note in a tax-deferred exchange involves the execution by the Buyer of a Buyer's Note as part of the consideration for the Buyer's purchase of the Relinquished Property. 

                                Example 1A: Adam Apple enters into a purchase agreement to sell Whiteacre to Betty Beans, provided that Betty Beans cooperates in Adam Apple's intended tax-deferred exchange. The purchase agreement provides that the price is $600, payable $400 cash and the balance payable by Betty Beans' execution of a Buyer's Note for $200.  

                The first issue that arises is whether the Buyer should execute the Buyer's Note in favor of the Exchangor or in favor of the Intermediary. The answer is that the Buyer's Note should be payable to the Intermediary rather than to the Exchangor, as the Intermediary is the party from whom the Buyer technically purchases the Relinquished Property. 

                                Example 1B: In Example 1A, Adam Apple subsequently executes an exchange agreement with an Intermediary and assigns the purchase agreement to the Intermediary. At the close of the First Escrow, Adam Apple deeds Whiteacre to Betty Beans, who delivers $400 cash to the Intermediary and executes a $200 note in favor of the Intermediary (the "Buyer's Note"). 

Note that in Example 1B direct deeding is utilized so as to avoid the imposition of double transfer taxes and recording fees. Reg. Section 1.1031(k)-1(g)(4)(iv)-(v). 

Disposition of the Buyer's Note 

                After receiving the Buyer's Note at close of the First Escrow, the Intermediary can do one of three things with it: deliver the Buyer's Note to the Exchangor; sell the Buyer's Note to a third party; or deliver the Buyer's Note to the Seller as part of the consideration for the purchase of the Replacement Property. Let's look at each of those alternatives. 

           Delivery to Exchangor 

                Clearly, the most practical thing for the Intermediary to do with the Buyer's Note is to transfer it to the Exchangor when the exchange has been completed. After all, the Exchangor has agreed to the terms of the Buyer's Note as part of the negotiations on the sale of the Relinquished Property. 

                                Example 2: In Example 1, Adam Apple then enters into a purchase agreement to buy Greenacre from Charlotte Chops for $600 cash and assigns that purchase agreement to the Intermediary. At the close of the Second Escrow, Adam Apple delivers $200 to the Intermediary, who pays $600 to Charlotte Chops (i.e., the $400 cash which it was holding and the $200 cash which it has received from Adam Apple). Concurrently, Charlotte Chops deeds Greenacre to Adam Apple and the Intermediary transfers the Buyer's Note to him. 

                Unfortunately, receipt of the Buyer's Note presents a substantial tax risk to the Exchangor since the Buyer's Note constitutes "cash boot" if and when it is received by the Exchangor. The Exchangor's realized gain will be recognized to the extent of the value of the Buyer's Note unless the Exchangor is entitled to offset cash boot paid in the exchange against the cash boot received. Reg. Section 1.1031(d)-2. 

                In Example 2, the "cash boot" which is being paid by the Exchangor (i.e. $200 cash) is a different form of "cash boot" than the Buyer's Note. It is not clear under existing law whether one type of cash boot may be offset against another type of cash boot. See Franklin G. Biggs (1978) 69 TC 905, aff'd (5th Cir. 1980) 632 F 2d 1171. 

                One possible solution to this problem would be for the Exchangor to execute an Exchangor's Note mirroring the terms of the Buyer's Note. Note than when an Exchangor's Note is utilized, it should be payable to the Intermediary and assigned to the Seller at close of the Second Escrow rather than be payable directly to the Seller.               

                                Example 3: In example 1, Adam Apple enters into a purchase agreement to buy Greenacre from Charlotte Chops for $600, payable $400 in cash and the balance payable by the Adam Apple's execution of a $200 note (the "Exchangor's Note") with the same terms as the Buyer's Note. At close of the Second Escrow, Adam Apple delivers to the Intermediary the Exchangor's Note. Concurrently, the Intermediary delivers to Charlotte Chops the $400 cash which it is holding and the Exchangor's Note which it has received from the Exchangor. Charlotte Chops deeds Greenacre to Adam Apple and the Intermediary delivers the Buyer's Note to him. 

                In Example 3, even though the Exchangor is "paying" cash boot in an amount equal to the Buyer's Note, and in a form virtually identical to the Buyer's Note, it is unclear whether the Exchangor is permitted to offset any cash boot received (i.e., the Buyer's Note) by any cash boot paid (i.e., the Exchangor's Note). Reg. Section 1.1031(k)-1(j)(3). 

Delivery to Seller

                 A second alternative is for the Intermediary to transfer the Buyer's Note to the Seller as part of the consideration for the Replacement Property. 

                                Example 4: In example 1, Adam Apple enters into a purchase agreement to buy Greenacre from Charlotte Chops for $600, payable $400 in cash and the balance payable by the assignment to Charlotte Chops of the Buyer's Note. Adam Apple assigns this purchase agreement to the Intermediary. At close of the Second Escrow, the Intermediary delivers to Charlotte Chops the $400 cash which it is holding and it endorses and delivers to Charlotte Chops the Buyer's Note. Concurrently, Charlotte Chops deeds Greenacre to Adam Apple. 

                This solution is ideal from a tax standpoint, as the Exchangor has not actually received the Buyer's Note and will not be treated as having constructively received it as long as the "qualified intermediary" safe harbor rules are followed. Reg. Section 1.1031(k)-1(g)(4).               

                Even if a Seller is willing to carry back financing, the Seller usually prefers to receive a note secured by the property he is selling (i.e., the Replacement Property) rather than receiving a note secured by a property with which he is totally unfamiliar (i.e., the Relinquished Property).                 

       Sale to Third Party 

                The third alternative is for the Intermediary to sell the Buyer's Note and to deliver the proceeds to the Seller as part of the consideration for the Replacement Property.  

                                Example 5: In Example 1, the Intermediary sells the Buyer's Note to an unrelated third party for $170. Adam Apple enters into a purchase agreement to buy Greenacre from Charlotte Chops for $600 cash. At close of the Second Escrow, Adam Apple delivers $30 to the Intermediary who delivers $600 to Charlotte Chops (i.e., the $570 which it is already holding plus the $30 received from Adam Apple). Concurrently, Charlotte Chops deeds Greenacre to Adam Apple. 

                In theory, a sale of the Buyer's Note by the Intermediary has no adverse effect on the Exchangor. However, if the Intermediary sells the Buyer's Note to a person or entity related to the Exchangor, the I.R.S. may contend that party is acting as the agent of the Exchangor, who then should be treated as having received cash boot.                             

         Conclusion 

Copyright © 1998 Richard A. Goodman