Posted by William L. Exeter on August 20, 2004 at 01:21:23:
Hi Lynn,
I am the president of an exchange company (Qualified Intermediary/Accommodator) and this is done all the time. So, the answer is absolutely yes!
The first decision that you have to make is whether or not you want to use the note as part of your 1031 exchange transaction so that 100% of the capital gain and depreciation recapture taxes are deferred (Section 1031), or if you want to process the note outside (separate) of the 1031 exchange so that it is taxable under the installment sale rules (Section 453).
The majority of clients typically want to defer 100% of their capital gains and depreciation recapture, so they structure the transaction so that the note is included as part of (inside) their 1031 exchange transaction. Here is how it would be structured in order to accomplish this.
The Qualified Intermediary (Accommodator) would be assigned into 100% of the Purchase and Sale Agreement/Contract for Sale and any applicable Escrow Instructions (if any). The note and deed of trust or mortgage would be completed with the Qualified Intermediary (Accommodator) as the beneficiary (owner) of the note. The Qualified Intermediary would then end up receiving and holding all of the cash and the note and deed of trust/mortgage at the closing of the relinquished property (sale) transaction. This is the easy part.
The more difficult part - or question - is what to do with the note now that it is in the name of and being held by the Qualified Intermediary. The “assets” held by the QI must be used for the acquisition of the replacement property.
There are essentially three (3) solutions here. The first is to ask the seller of the intended replacement property if he or she would accept the cash AND the note as consideration for the replacement property, which they typically will not be willing to accept. The second is to sell the note to an investor at either face value or a discount, which could be rather expensive but plausible. The third is to have the Taxpayer/Exchangor contribute the equivalent amount of cash into their own exchange account with their Qualified Intermediary in order to complete the acquisition of their replacement property and then have the QI assign the note back to them AFTER the 1031 exchange has been completed. The capital gain and depreciation recapture income tax consequences are deferred into the replacement property.
The investor/Taxpayer/Exchangor should plan this strategy well in advance and have a solution lined up for the note. In most cases the only practical solution is for the Taxpayer/Exchangor to contribute cash out of their own resources into the 1031 exchange account.
Hope this helps.