To avoid incurring the expense and hassle of a reverse exchange transaction, taxpayers have consistently tempted their sellers with incentive payments, larger earnest money deposits or short-term lease agreements, which contain option-to-purchase provisions.  The ultimate goal, of course, is to position the acquisition of the replacement property to occur after the sale of the relinquished property.

Taxpayers who have unsuccessfully negotiated with the sellers of their replacement property can now negotiate with the purchasers of their relinquished property.  This reverse exchange avoidance technique involves seller financing.   If the reason for the reverse exchange process’ contemplation is that the purchaser is unable to obtain timely financing, then selling the relinquished property, to the purchaser via an installment contract, should be considered. The installment arrangement allows the purchaser more time to obtain independent third-party financing since the taxpayer acts as a temporary lending source.  In return, the purchaser provides the taxpayer with a promissory note, as consideration for the relinquished property, which is to be satisfied as of a designated maturity date.  The satisfaction of the promissory note can be accomplished over a period of installment payments or in one lump sum. 

However, whenever seller financing is coupled with a 1031 exchange process, the steps that must be taken must be carefully arranged.  Section 1031(a)2 of the IRC allows for neither the disposition nor acquisition of a note.  Therefore, when the taxpayer receives a promissory note, as consideration for the sale of his relinquished property, the taxpayer is viewed as having received non-qualifying property.  The taxpayer’s ultimate goal is to convert the non-qualifying property into qualifying property.  The conversion steps are threefold:

1. the promissory note must be made payable to the order of the Qualified Intermediary – not the taxpayer,
2. the promissory note must be booked as an asset of the Qualified Escrow Account, that has been established by the Qualified Intermediary, and
3. ensure that the promissory note will be converted into cash before the replacement property’s acquisition date.  

How a taxpayer converts the note into cash is accomplished in one of four ways: 

1. arrange for the note to mature prior to the acquisition of the replacement property,
2. convince the seller of the replacement property to take the promissory note as consideration for the replacement property,
3. sell the promissory note on the open market, or
4. enter into a Note Purchase Agreement to buy the promissory note from the Qualified Intermediary. 

Methods 1, 2 and 3 are often impossible feats because most purchasers need at least one year to satisfy the promissory note, most replacement property sellers do not want to be in receipt of endorsed promissory notes and most promissory notes cannot be expeditiously sold on the open market.  Therefore, the fourth way is the most frequently utilized method by which promissory notes are converted into cash.  This method, although frequently utilized, was previously viewed as tax aggressive.  However, as of 2002, a taxpayer can purchase the promissory note from his Qualified Intermediary. 

In accordance with Private Letter Ruling 200241016, a 1031 taxpayer can enter into an agreement, with the Qualified Intermediary, to purchase the promissory note from the Qualified Intermediary.  According to this “note purchase agreement,” the taxpayer will provide the taxpayer with the cash to satisfy the promissory note and, after the cash has been deposited into the Qualified Escrow Account, the Qualified Intermediary will  endorse the note, without recourse, to the taxpayer.  After the note is successfully converted into cash, the Qualified Intermediary is equipped to acquire the identified like-kind replacement property.

Although this reverse exchange avoidance technique ensures an expeditious sale and, therefore, an exchange mechanism that does not necessitate the intervention of an Exchange Accommodator (a/k/a a Parking Intermediary), this technique may be cost- and time-prohibitive.  The taxpayer should compare this technique’s cost and procedural steps with the reverse exchange process's cost and procedural steps.  The decision to use this avoidance technique will depend on both the taxpayer’s ability to be fully compensated, via the terms of the promissory note, for having provided seller financing to his purchaser, and the expertise of the taxpayer’s counsel and Qualified Intermediary.

Any questions concerning the aforementioned, or for a 1031 Package, please contact Julianna A. Clementi-Ryan, Vice President, Central US Operations of Nationwide Exchange Services at 312-803-7504; jclementi@nationwide1031.com.