How to Provide Counsel on Carry Back Notes

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This article will focus on how accountants can provide value and build credibility by counseling clients on the complexity involved with carry back financing in 1031 transactions.

In cases in which a buyer does not have adequate short-term financing, sellers can choose to accept a carry back note to dispose of their relinquished property. In this situation, there are 4 different ways in which this note can be handled within the exchange transaction.

The seller can also decide to take the note out of the exchange and pay taxes on income received to the extent of the gain. However, if kept within the exchange, there are four different options for dealing with the note. Ideally, clients can receive counsel on this issue from a facilitator or tax attorney, but this is not possible then accountants have an opportunity to step in and provide counsel.

Option 1: Buy the Note from the 1031 Exchange

Taxpayers can buy the carry back note from the exchange. This means that the taxpayer replaces the note with cash in the amount which will eventually be received from the buyer.

This is a highly desirable option, as it disposes of the note and avoids taxation on the note when the funds are sent from the buyer. However, the most common problem is that this option is not available.

This option requires significant cash reserves on the part of the seller and this isn’t always possible. Moreover, even if the seller has sufficient reserves, he or she has to be willing to transfer this up front and accept the deferred payment from the buyer. This option is perhaps the simplest and best way to handle the problem, but it’s generally the least accessible.

Option 2: Sell the Note on the Open Market

This option allows the note to be replaced with cash, but it requires an outside party to buy the note. The difficulty of this approach is locating the buyer and, even if a buyer can be found, there’s also the issue of the selling price.

Typically, notes of this kind are sold at a discounted rate. This usually means that the selling price will be somewhere between 15 to 30 percent below face value. This is perfectly understandable, given that the buyer of the note is trading a lump sum up front for deferred payments. But this also means that the seller of the relinquished property will have less cash to finance a new acquisition. 

The desirability of this option depends in part on the end goals of the seller. If the seller needs the cash which would be lost through selling the note at a discounted price, then this option may not be feasible. If, on the other hand, the seller can cope with less cash then this option might be workable.

Option 3: Use the Note Toward the Acquisition

This option might surpass Option 1 in its attractiveness. In this approach, the taxpayer uses the note itself as compensation toward the acquisition of more property. In other words, convince the seller of the replacement property to accept the note as compensation.

The reason why this option is so attractive is that it avoids having to bring in the taxpayer’s own cash to replace the note and avoids the drawbacks of selling on the open market. Of course, the biggest issue here is accessibility.

Finding a replacement property seller who’s willing to accept the note can be a difficult task. Things will ultimately depend on the needs of the replacement property seller. If you can find a seller who’s financial condition allows him or her to accept deferred compensation, then this option may be possible. But this will certainly not always be the case.

Option 4: Allow the Note to Mature During the Exchange

The final option is to allow the carry back note to mature during the course of the exchange. In a delayed exchange, the taxpayer has a maximum of 180 days to complete the transaction. Therefore, if the note matures during this period of time, then the taxpayer can wait until the maturity date of the note and then simply use the cash as normal.

This option is perhaps the least commonly used, in part because it is not always available. Many notes will not have a maturity date of less than 180 days and so this option will not be possible in many cases. And, even when it is available, it may not be desirable.

This option means taxpayers will be delaying the acquisition of new property and delaying in this way could cause them to miss out on a purchase opportunity. The market won’t stop and wait just because you have a note which needs to mature.

If the buyer waits, they could end up losing out on the property you would prefer to acquire. Of course, this option means you won’t need to bring in cash (Option 1) or sell at a discounted price (Option 2). But it will still complicate your transaction and force you to wait longer than you might prefer to wait.

Related Articles

How to Guide Clients on 1031 Taxation

Three 1031 Related Party Rules You Should Know

About Jorgen Rex Olson

About Jorgen Rex Olson

Jorgen Rex Olson is a graduate of Washington State (B.A., cum laude, 2008) and the Indiana University (McKinney) School of Law (J.D., 2012). He writes for Mackay, Caswell & Callahan, P.C., one of the leading tax law firms in New York State.

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