If a seller agrees to carry a note on a sale of property, the IRS considers the note taxable. As payments on the note are received, the principal portion of the payments is subject to capital gains tax and the interest portion is subject to ordinary income tax. If, however, the seller includes the note in the 1031 exchange, there is a viable alternative to paying this tax: the note is made payable to JELD-WEN 1031. This avoids the constructive receipt of the note by the exchanger. JELD-WEN 1031 then holds the note as part of the exchange. Once the note is received by JELD-WEN 1031, the exchanger has four alternatives for attempting to use the note as part of the exchange:
Sell the note to a third party
The exchanger finds an investor willing to purchase the note, thereby replacing the note with cash. JELD-WEN 1031 assigns the Note to a third party and the cash proceeds are added to the existing cash in the exchange value account. Then all proceeds are available to acquire the replacement property.
Exchanger purchases the note from JELD-WEN 1031
The note is replaced with cash paid by the exchanger and deposited to the exchange value account. The note is then assigned to the exchanger upon receipt of the cash deposit. The cash can then be used to acquire replacement property.
Use the note toward down payment on the replacement property
The seller of the replacement property accepts the note as partial payment towards the purchase price. In this scenario, the note is assigned to the seller by JELD-WEN 1031 and delivered to the seller at closing.
The payer pays off the note prior to closing the replacement property
The note is paid off during the exchange and the proceeds are added to the exchange value account, which must be completed prior to the acquisition of the replacement property. All proceeds are then available to acquire the replacement property. Maturity date of the note and the closing date of the replacement property must seriously be considered when choosing this option. If an exchanger is unsuccessful in negotiating any of the above options JELD-WEN 1031 assigns the Note to the Exchanger at the completion of the exchange. The note will be considered "boot" and subject to capital gains tax. The exchanger may retain the tax benefits of the installment method under Section 453 of the Internal Revenue Code. The exchanger should always consult with their tax advisor when electing to include seller financing in an exchange.