You can combine a 1031 exchange with owner financing, but the seller-carried promissory note is the piece that causes the tax problem. A note is not like-kind real property, so if you take it in your own name at closing, its face value is taxable boot in the year of the sale. The workaround is to make the note payable to your qualified intermediary at closing and convert it into value that flows into the replacement property within the 180-day exchange window. Owner financing on the property you’re buying is a different story and creates no boot issue at all.
Why a Seller-Carried Note Is Boot
Section 1031 defers capital gains tax only when you exchange real property held for business or investment for other real property of like kind.1Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment Anything else you receive in the deal — cash, personal property, debt relief, or a promissory note — is boot, and boot is taxable up to the amount of your realized gain.2eCFR. 26 CFR 1.1031(b)-1 – Receipt of Other Property or Money in Tax-Free Exchange
The IRS treats the face value of a note the same as receiving cash. Pocket the note and you owe tax on it, even though no money has actually changed hands yet. That is the central problem to solve on the sell side.
Selling with Owner Financing: Route the Note Through the QI
At the closing of your relinquished property, the qualified intermediary must be named as the payee on the note and as the beneficiary of any deed of trust or mortgage securing it. You cannot take possession of the note, even briefly. Holding it counts as constructive receipt and turns it into taxable boot.
Once the QI holds the note, it needs to be converted into value that goes toward the replacement property. Three ways to do that:
- Transfer the note to the seller of your replacement property as part of the purchase price. If that seller will accept it, the full note value stays inside the exchange and remains deferred. This is the cleanest outcome.
- Sell the note to a third-party note buyer for cash. Secondary-market note sales almost always involve a discount, sometimes a steep one, so the QI receives less than face value. You may need to cover the shortfall out of pocket to avoid boot.
- Buy back the note yourself with separate funds. You pay the QI cash equal to the note, and the QI applies that cash to the replacement purchase. It works, but it requires liquidity you probably didn’t plan for.
Every one of these has to be completed within the 180-day exchange period. If the note is still sitting with the QI when day 180 passes, its value becomes taxable boot. Note sales on the secondary market typically need several weeks of due diligence and negotiation, so waiting until month five to start looking for a buyer is how deals fall apart. Start the disposition process the day the relinquished property closes.
The Installment Sale Fallback
If the note ends up as boot — either because you never assigned it to the QI or because the QI couldn’t convert it in time — you don’t necessarily owe the entire tax bill up front. Section 453 lets you report the gain using the installment method, recognizing income as you actually receive principal payments on the note.3Office of the Law Revision Counsel. 26 U.S. Code 453 – Installment Method
Section 453(f)(6) coordinates installment reporting with a 1031 exchange. The like-kind portion stays fully deferred; the total contract price and gross profit are both adjusted to exclude the like-kind property received.3Office of the Law Revision Counsel. 26 U.S. Code 453 – Installment Method The cash the QI used to buy your replacement remains tax-deferred. You recognize gain only as the buyer pays down the note. This isn’t true deferral on the note portion, but spreading the tax across a payment schedule is often much better than a single-year hit.
Buying with Owner Financing Is Simpler
When the seller of your replacement property carries a note for part of the price, you’re taking on debt, not receiving property. There is no boot issue. The note is a liability you owe, and liabilities on the replacement side actually help you.
The face value of that owner-carried note counts toward your total debt on the replacement property, which helps satisfy the debt replacement requirement. If your relinquished property carried $500,000 in debt and you could only secure $300,000 in conventional financing, a $200,000 owner-carried note from the seller closes the gap. Your total replacement cost (QI cash plus bank financing plus the owner-carried note) needs to equal or exceed the net sale price of the relinquished property.
This is genuinely useful for property types that don’t fit conventional underwriting: commercial buildings, raw land, unusual assets. Seller financing fills the gap without creating any tax complication on the exchange side.
The Debt Replacement Rule and What Netting Can’t Fix
Full deferral requires trading up in both equity and debt. If you had a mortgage on the relinquished property, the total debt on your replacement needs to be at least as large. A shortfall is mortgage boot, taxable up to your realized gain.4Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031
Some offsetting is allowed. Liabilities assumed by each party can be netted, so you’re only taxed on the net difference.2eCFR. 26 CFR 1.1031(b)-1 – Receipt of Other Property or Money in Tax-Free Exchange Extra cash you contribute at closing can eliminate mortgage boot. If you owed $500,000 on the relinquished property and took on only $400,000 in new debt, adding $100,000 in cash wipes out the shortfall.
The rules do not run in both directions, and this is where planners get caught. Extra cash offsets mortgage boot. Extra debt on the replacement property offsets lesser debt on the relinquished property. But extra debt on the replacement does not offset cash boot you received. Any cash you pulled out of the exchange stays taxable no matter how much new debt you took on. Treat cash withdrawn as taxable, full stop.
What You Actually Pay When Boot Happens
When boot is unavoidable, the tax treatment follows a specific order. Depreciation recapture is recognized first, at a maximum federal rate of 25% on the depreciation you previously claimed.5Internal Revenue Service. Form 8824 – Like-Kind Exchanges Any remaining gain above the recaptured depreciation is long-term capital gain at 0%, 15%, or 20% depending on your taxable income. Most states add their own income tax on top.
The ordering matters. If you receive $100,000 in boot and have claimed $80,000 in depreciation, the first $80,000 is recapture at up to 25%, and only the remaining $20,000 gets the lower capital gains rate. On a property held for many years, recapture is often the bigger bite.
Interest on any note you personally hold is ordinary income taxed at your regular rate, separate from the exchange. If the QI transferred the note to the replacement seller, that seller gets the interest payments, so this only matters when you end up holding the note yourself.
Deadlines, Documentation, and Your QI
Two statutory deadlines govern every exchange. You have 45 days from the sale of the relinquished property to identify replacement properties in writing, and 180 days to close on the replacement (or your tax return due date with extensions, whichever comes first).1Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment No extensions, no weekend relief, no exceptions.
Owner financing compresses that timeline because the note disposition is an extra project running alongside the replacement search. Whatever exit route you’re planning for the note, work it in parallel with property identification from day one.
Documentation carries these deals through IRS review. The note assignment to the QI must be executed at or before the closing of the relinquished property sale. The exchange agreement, closing instructions, and settlement statements need to identify the note as part of the exchange proceeds. If the note later transfers to the replacement seller, that document should reference the exchange too. Gaps in the paper trail give the IRS grounds to treat the note as boot you received personally, and you can’t fix that after the fact.
Your qualified intermediary cannot be someone who has served as your employee, attorney, accountant, investment banker, or real estate broker within the prior two years, and cannot be an entity you own or control by more than 10%. Professionals whose only role has been facilitating 1031 exchanges, and routine title, escrow, or trust services from financial institutions, are excepted.4Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031 Report the completed exchange on Form 8824, which computes your recognized gain, deferred gain, and adjusted basis in the replacement property.6Internal Revenue Service. Instructions for Form 8824