A seller we worked with had a clean sale lined up: $1,500,000 for a small retail building, a motivated buyer, a 1031 exchange teed up to roll the whole gain forward. Then the buyer asked her to carry $300,000 of the price as a note, paid back over five years. It was a reasonable ask, and it nearly broke her exchange, because a promissory note is not money, and a 1031 exchange runs on money.
Here is the problem, and the three ways out of it.
Why a note is a problem the exchange did not expect
A 1031 exchange defers tax only to the extent you take the proceeds of your sale and reinvest them, through your qualified intermediary, into replacement property. The mechanism assumes cash: the buyer pays, the Qualified Intermediary holds the cash, and the cash buys the next building.
A seller carryback breaks that assumption. When you agree to finance part of the price, that slice of your sale does not arrive as cash. It arrives as a note, a promise to pay you over time. And a note made out to you, sitting in your pocket, is not reinvested into replacement property. In the eyes of the exchange it looks like proceeds you kept, which is the definition of boot, the taxable portion of an otherwise deferred deal. Carry a $300,000 note the wrong way and you can turn a fully deferred sale into one with $300,000 of taxable gain, even though you never touched a dollar of cash.
Option one: keep the note and pay the tax on it
The simplest path is to accept the consequence. The note is made payable directly to you, the cash portion of the sale flows through your intermediary and defers as normal, and only the note is taxable. The redeeming detail is that installment-sale treatment usually applies, so you generally recognize that gain gradually, as you receive principal payments over the life of the note, rather than all at once in the year of sale.
For a seller who wanted some income anyway, this is often fine. You defer the bulk of the gain through the exchange and spread the tax on the financed slice over several years. It is a partial exchange, entered with eyes open.
Option two: buy the note back with your own cash
If you want to defer everything, the note has to become cash inside the exchange. The classic way: during the exchange period, before the funds are used, you purchase the note from your intermediary using your own outside cash, at face value. Your personal money goes in, the note comes out to you, and the intermediary now holds the equivalent cash, which reinvests into your replacement property like any other proceeds.
The catch is obvious. You need liquid funds outside the exchange equal to the note. Many sellers do not, or do not want to tie them up. When the cash is there, though, this cleanly rescues full deferral, and you simply hold the note personally afterward as an ordinary investment.
Option three: use the note to buy the replacement
The most elegant option, and the hardest to arrange, is to spend the note itself as part of the purchase price of your replacement property. The note is issued in the name of your intermediary, and the intermediary transfers it to the seller of your replacement property as part of your payment. The note never becomes boot because it is used, inside the exchange, to acquire the new building.
It works beautifully on paper. In practice it requires a replacement-property seller willing to accept a third party's note as payment, which is uncommon, so we treat it as available rather than dependable.
What we tell clients before they agree to carry
Structure decides the tax here, and structure has to be decided before you sign, not after. Once the note is written payable to you at closing, most of your good options are gone. The order of operations that keeps the exchange intact:
- Flag the carryback early. The moment seller financing enters the negotiation, it becomes an exchange-structuring question, not just a deal term.
- Decide which slice defers. Are you deferring the whole gain, or accepting the financed portion as taxable installment income? That choice drives everything else.
- Get the note made out correctly. Payable to the intermediary if you intend to keep it inside the exchange; payable to you only if you have accepted it as boot.
- Confirm the numbers with your CPA. Basis gets allocated first to the replacement property and only the excess to the note, and your CPA determines exactly how much gain each piece carries.
Seller financing is a genuinely useful tool. It closes deals that would otherwise stall and it can hand you a stream of interest income. It just cannot be an afterthought in an exchange, because the note is the one part of your sale price the intermediary cannot reinvest for you unless you set it up to let them. Handled early, as part of our exchange process, it slots in cleanly. Handled late, it is the quiet reason a "fully deferred" sale shows up with a tax bill.
Questions we field about seller financing and 1031 exchanges
Does seller financing disqualify a 1031 exchange?
No. You can carry a note and still do a valid exchange. The question is only whether the note becomes taxable boot or stays inside the exchange, which depends on how it is structured before closing.
Is the carryback note taxable?
If the note is made payable to you and kept outside the exchange, the gain attributable to it is taxable, though installment-sale treatment usually lets you recognize that gain gradually as you receive principal payments rather than all at once.
How do I keep the note from creating boot?
Two main ways: buy the note back from your qualified intermediary during the exchange using your own outside cash, or have the note issued to the intermediary and used to acquire the replacement property. Both keep the note inside the exchange so it is not treated as proceeds you kept.
Can I use the note as part of the down payment on my replacement property?
Sometimes. If the replacement seller agrees to accept it, the note can be transferred from your intermediary to that seller as part of your purchase, avoiding boot. It requires a willing counterparty, so it is not always available.
When do I need to decide how to handle the note?
Before closing, ideally the moment seller financing enters the negotiation. Once the note is written payable to you at the sale, most options for keeping it inside the exchange are lost, so the structuring conversation has to happen up front.