From time to time, a buyer may ask a seller to carry back a promissory note (“Note”) on the acquisition of real property. This strategy of the seller essentially acting as the lender is referred to as “seller financing” or a “seller carry-back.”
A seller carry-back Note can be a powerful sales tool when negotiating and structuring real estate transactions, especially in shifting rate environments or tight credit markets. If done correctly, this type of financing can also be an effective tax planning strategy for those who do not want to 1031 exchange into another property.
In a situation where the holder of the carry-back loan wants to carry the Note, there are four different options for handling the Note:
1. Buy the Note
The seller can buy out the Note by replacing it with cash in the full amount owed to the seller. This option disposes of the Note while avoiding taxation when the funds are sent from the buyer. One downside of this option is that it requires significant cash reserves on the part of the seller, and may not always be possible. Also, the seller must be willing to transfer the Note up front and accept deferred payments from the buyer. For tax purposes, this is often a preferred method, although not all sellers are in a position to execute it.
2. Sell the Note on the Open Market
This option allows for the Note to be replaced with cash, but it requires a third party to buy the Note. Typically, the hardest part is finding a willing buyer and an agreed-upon price because Note buyers typically expect a discount on seller carry-back Notes. The discounted rate could mean a 15 to 30 percent drop below face value. However, the third party’s expectation of a discount can be seen as reasonable, given that the buyer is trading cash for a Note with deferred payments. If the seller needs cash immediately, and a third party purchaser is willing to buy the Note, it may be beneficial to explore this option.
3. Use the Note Towards Another Acquisition
This option allows the Note holder to use the Note as compensation for the acquisition of another piece of real property. This strategy is an attractive approach if the seller of the replacement property is willing to accept the Note as compensation for the purchase. This approach can be extremely beneficial because the Note holder does not have to bring his or her own cash to replace the Note, nor do they have to sell the Note at a discount on the open market. One of the biggest hurdles, however, is accessibility. The Note holder needs to find a replacement seller who is positioned financially to take on deferred payments for part or all of the purchase price.
4. Allow the Note to Mature
A final option is to allow the carry-back Note to mature. If the Note holder allows the Note to fully mature, he or she can simply use the cash as normal —assuming it is paid in full upon maturity. This option is not utilized very often because a seller carry-back Note generally does not mature in under 180 days — the time allowed for 1031 exchanges — and most Notes have a term of several years or more. Another downside to this option is the inherent delay to acquiring another property, and it could force the Note holder to forego a deal that may present itself during the maturity period.
