As you probably know, in a like-kind exchange, any sale proceeds that you do not apply to purchasing a new investment property will be taxable (up to the total gain on the property). The challenge with making a like-kind exchange of property in a seller-financed sale is that the seller doesn’t receive any (or very little) cash at closing.  As a result, even if the seller rolls that cash over into a new property, subsequent payments received on the note will be taxable (to the extent of gain). The question is, how can a seller get cash (instead of the seller’s note) to the qualified intermediary (QI) so the QI can fully reinvest the sale proceeds into the new property.

One approach may be for the seller to purchase the note from the QI for cash. For example, if a seller sold a property for $100,000 with $20,000 cash at closing plus a note for $80,000, the seller could buy the note from the QI for $80,000, leaving the QI with $100,000 cash to use to purchase the replacement property. (The buyer of the note would have a tax basis in the note equal to the amount paid for it, so the receipt of subsequent payments on the note would not be taxable except to the extent of interest received).

Coming up with cash to buy the note may, of course, be easier said than done.  Does the seller have the cash? Will a lender be willing to loan the seller that cash? Is there a third party that would be willing to purchase the note? As the numbers get larger, this may become more challenging. 

If the property sold is subject to existing debt, and the replacement property is purchased in part with seller financing, this complicates the analysis somewhat but doesn’t change the ultimate result. On the positive side, the third-party debt may reduce the amount of the buyer note payable to the seller and, therefore, reduce the amount of cash that would be needed to buy the note.

Bottom Line:  While the need for cash may make this a challenging structure, there may be an opportunity to defer gain on seller-financed property in a Section 1031 exchange.

 “When you’re in jail, a good friend will be trying to bail you out. A best friend will be in the cell next to you saying, ‘Damn, that was fun.’” —Groucho Marx