1031 Exchange Note Transactions: An option for real estate owners to consider
For years, real estate investors have enjoyed the benefits of tax deferral under Section 1031 of the Internal Revenue Code (“1031 Exchange”). Under the 1031 Exchange rules, sellers of U.S. real estate are able to defer some or all of the capital gains tax on sales proceeds which are re-invested in replacement properties identified and purchased within particular timeframes after the date of the sale. But what if some of the seller’s members prefer to pocket their share of the sales proceeds (and pay the resulting capital gains tax) rather than re-investing those funds in a replacement property? One approach is to implement a like-kind exchange with a note structure (“1031 Note Transaction”). Role of the Qualified Intermediary
In a typical 1031 Exchange, a qualified intermediary (“QI”) holds the cash proceeds received from the buyer of the relinquished property until they are re-invested in one or more replacement properties. This is done in an effort to prevent the cash proceeds from being characterized as taxable “boot” income to the seller. However, in a 1031 Note Transaction: (1) the QI takes receipt of the cash proceeds from the sale; (2) a portion of the cash proceeds is set aside and used to purchase the replacement property; (3) the remainder of the cash proceeds is retained; and (4) a promissory note is issued to and in favor of the seller in an amount equal to such remainder of the cash proceeds (“Remainder Note”).