CARRYBACK FINANCING
ON THE RELINQUISHED PROPERTY

Often Exchangors are required to offer financing to the Relinquished Property Buyer.

Carryback Financing on the Relinquished Property jeopardizes the exchange's viability because the amount of the carryback financing will not qualify for the exchange unless the carryback financing is used to acquire the Replacement Property.

For there to be any chance for the carryback financing to qualify for the exchange, the Facilitator must be the Holder of the Note and the Beneficiary on the Deed of Trust given by the Relinquished Property Buyer.

The carryback financing can be used to acquire the Replacement Property by either:

A.  Transferring the Carryback Financing to the Seller of the Replacement Property - If the Seller of the Replacement Property will accept the Note and Deed of Trust from the Relinquished Property Buyer and the carryback financing is transferred to the Replacement Property Seller within the exchange deadlines, the carryback financing will qualify for the exchange.

Problem:  The Seller of the Replacement Property will be taxed on the amount of the carryback financing transferred to him as though he had received cash at the closing.  It is unlikely that a Replacement Property Seller would be willing to accept such tax consequences.  Therefore it is improbable that this device can be used.

Problem:  Normally Sellers want an I.O.U. from the Exchangor, not the Exchangor's Buyer.  Normally Sellers want a lien on their property, not on the Exchangor's old property.

B.  Converting the Carryback Financing to Cash by Sale to a Third Party - The Facilitator could sell the Note and Deed of Trust (normally at a discount) to a third party.  The cash from the Note's sale could then be used by the Facilitator to purchase the Replacement Property. 

The party buying the Note and Deed of Trust, during the exchange, should be someone unrelated to the Exchangor.  If the IRS can establish that the party who bought the Note, during the exchange, is related to the Exchangor, the IRS could argue that the Exchangor, not the buyer of the Note, received the Note.  Then the Exchangor could be taxed on the amount of the Note, and the Exchangor would have received no exchange benefits from the sale of the Note. 

Problem:  The amount of discount required to be taken to sell the Note to an unrelated third party could be substantial.   The discount could exceed the tax benefits of using the Note in the exchange.

C. Converting the Carryback Financing to Cash by Sale to Related Party or Exchangor to Complete The Exchange -

A third alternative is to sell the Note to a party related to the Exchangor or to sell the Note to the Exchangor at completion of the exchange.  This is done by the Facilitator depositing the Note into the Replacement Property escrow with instructions to the escrow agent to sell the Note for cash and to deliver the Note to the related party or the Exchangor only after closing of the Replacement Property.

This alternative can only work if the exchange is completed upon closing of the Replacement Property, that is, with the Replacement Property closing, the Exchangor will have received all of the properties identified.

Problem:  The Exchangor or the party related to the Exchangor must have sufficient funds to purchase the Note.  While this approach should work in theory, it has not been blessed by the IRS or court ruling.

If none of the three alternatives work, the Note balance will not be used in the exchange and the Note and Deed of Trust will be transferred to the Exchangor at the end of the exchange.  The Regulations clearly state that the installment sale rules (pay tax as you get paid) will apply to a Note transferred to the Exchangor by the Facilitator at the end of the exchange.

Exchangors should first attempt to receive a full cash payment for their Relinquished Property.  None of the alternatives listed above are easy or painless.  Carryback Financing presents a real problem for the exchange.