THE 1031 EXCHANGE INSTITUTE

Buying Distressed Notes

I overheard a conversation recently while circulating at a commercial real estate networking event in Los Angeles. The person speaking said they were buying distressed loans (promissory notes) at significant discounts from commercial banks. The loans were already in foreclosure, and the person speaking (buyer) wanted to buy the notes now so that they would end up with the actual real estate by completing the foreclosure.

Buying Notes Through a 1031 Exchange

She indicated that she would like to sell certain real estate that she already owns through a 1031 exchange, and then acquire the promissory notes from the commercial bank as her like-kind replacement property to complete her 1031 tax deferred exchange transaction.

She indicated that she had asked a couple of 1031 exchange Qualified Intermediaries about doing just this but that the two Qualified Intermediaries said that the transaction would not qualify for 1031 exchange treatment because the installment notes were personal property and not real estate.

Expertise and Experience Counts Here

The answer that she received appears to be correct on the surface.  She wants to sell real estate, so it stands to reason that she must acquire real estate in order to qualify for tax deferred exchange treatment under Section 1031. 

However, there actually is a way to structure the transaction so that it will qualify as a 1031 tax deferred exchange.  The concept is relatively easy and straight forward.  The strategy combines the concepts of the Reverse 1031 Exchange parking structure and the Build-To-Suit 1031 Exchange improvement strategy. 

Reverse 1031 Exchange Parking Structure

She could implement the Reverse 1031 Exchange parking structure under Revenue Procedure 2000-37 where the note would be acquired and "parked" by the Exchange Accommodation Titleholder (EAT) as her intended like-kind replacement property. 

The note is absolutely personal property as the two 1031 exchange Qualified Intermediaries pointed out to her when asked if it could be done.  It is clearly not real estate, yet. 

Build-To-Suit 1031 Exchange Improvement Strategy

Real estate is often acquired and parked by an Exchange Accommodation Titleholder in order to improve the property.  The real estate is then transferred to the taxpayer to complete his or her 1031 tax deferred exchange once the improvements have been completed.  This is referred to as an Improvement 1031 Exchange or a Build-To-Suit 1031 Exchange or a Construction 1031 Exchange. 

The same concept can be used for her proposed 1031 tax deferred exchange.  The note would be acquired and parked by the EAT.  The EAT would "improve" the property by completing the foreclosure.  The EAT would end up with the actual real estate upon completion of the Trustee's Sale.  The real estate can then be transferred to her to complete her 1031 exchange. 

You really can acquire a Promissory Note as part of your 1031 tax deferred exchange transaction as long as the like-kind replacement property is actually a real property interest when it is received by the taxpayer completing the 1031 exchange.