Are you taking back a mortgage at the sale of your relinquished property? Selecting the best option

Written By Diane Schaefer, CES™ and President of Exchange Solutions, Inc., N.Y.

Early in the structuring of an IRC 1031 exchange, the taxpayer and Qualified Intermediary (QI) need to discuss whether or not the exchangor is taking back a mortgage.  Your QI should offer the list options that could possibly be utilized in order to defer the gain on that mortgage. The taxpayer (exchangor) should carefully consider whether or not boot is to be recognized in this transaction or employ it as an instrument in acquiring the replacement property on the second leg of the exchange. Boot is defined as cash or property other than property qualifying as such for non-recognition in an exchange of like kind property)  (IRC 1031(b)). The exchangor’s options to utilize the pure purchase money mortgage in an exchange are to lend, buy, sell or use the mortgage.

If the exchangor chooses to lend the note as part of the exchange transaction, at the closing of the relinquished property, the exchangor lends personal funds equal to the amount of the mortgage directly to the QI. The note and mortgage are then made in favor of the exchangor wherein it is delivered to the exchangor at the time of closing.  Since the QI received the full face value of the note, it is not subject to capital gain and the exchangor would report the interest portion of the payments received as interest income.

If the exchangor opts to buy the note as part of the exchange transaction, the mortgage and note are made directly in favor of the QI at closing of the relinquished property. The QI would receive the mortgage payments either in the form of principal and/or interest until such time that the exchangor has sufficient funds to purchase it at the remaining principal balance due. The exchangor would then deposit that amount directly with the QI and the intermediary assigns the mortgage to the exchangor.  The QI is then able to acquire the replacement property since it has received the remaining principal and the prior monthly mortgage payments.  This option is also not subject to capital gains tax.

The third option is to sell the mortgage to a third party. At the closing of the relinquished property, the note and mortgage are made in favor of the QI wherein the QI receives payments due on the mortgage until such time that the exchangor negotiates the sale of it to a third party lender. The third party funds the remainder due on the note directly to the QI wherein the intermediary would assign the mortgage to the new party.  At this time the QI holds full exchange equity in cash in order to acquire the replacement property.

Lastly, the exchangor can attempt to use the mortgage to acquire the replacement property and not be subject to capital gain.  At the relinquished property closing, the mortgage and note are drawn in favor of the QI  payments and are made directly to the QI until the exchangor is able to negotiate an assignment of the mortgage to the seller of the replacement property as consideration for acquiring the replacement property. The QI would then assign the mortgage to the seller of the replacement property at the time of closing on the acquisition.  However, this is not a common practice since most sellers desire cash at closing.

If the exchangor is willing to accept the pure purchase money mortgage as boot, none of the above options need be considered.  The mortgage and note are made in favor of the exchangor and delivered to the exchangor at time of closing on the relinquished property. The full value of the note is subject to capital gain and may be reported using the installment method of IRC 453 over a period of time.

When structuring the first leg of an exchange that involves taking back a mortgage, it is important for the taxpayer to analyze all options to determine how they will utilize the mortgage as part of the exchange.  However, the taxpayer should always seek the advice of tax counsel to determine whether they will include the mortgage and defer the gains tax or receive it as taxable boot in the exchange transaction.