Buying an Installment Note as Like-Kind Replacement Property in a 1031 Exchange

Buying Troubled Installment Notes
Recently I heard a discussion about selling real estate and the desire to acquire a troubled installment note as part of a 1031 exchange. The person indicated that they wanted to buy troubled notes (installment notes) at discounted values from financial institutions. The notes were in the foreclosure process, and the person wanted to acquire the loans today so they could end up owning the actual real property at the completion of the foreclosure proceedings.

Buying Loans in a 1031 Exchange
He said he wants to dispose of real property that he already owns by structuring a 1031 tax deferred like kind exchange, and then wants to buy the installment notes (loans) from the financial institution as his like-kind replacement property to complete his 1031 exchange.

Two 1031 exchange Qualified Intermediaries that he had approached about doing just this said the proposed 1031 tax deferred exchange transaction doesn't work for tax deferred exchange treatment under Section 1031 of the Internal Revenue Code because the promissory notes (loans) were in fact personal property and not real property.

Significant Value Lies in Expertise and Experience
The responses received from the two Qualified Intermediaries appear to be correct when viewed at the surface. He is going to dispose of real property, so it stands that he must buy real property to qualify for 1031 exchange treatment.

There is a creative way to structure the proposed 1031 exchange transaction so that it does in fact qualify as a 1031 exchange transaction. The strategy is very easy. The 1031 exchange strategy combines the concepts of the Reverse 1031 Exchange parking structure and the Build-To-Suit 1031 Exchange improvement strategy.

Parking Structures in a Reverse Exchange
He can use a Reverse 1031 Exchange parking structure under Revenue Procedure 2000-37 where the installment note (loan) is bought and "parked" or held by an Exchange Accommodation Titleholder as the intended replacement property.

The installment note (loan) is currently personal property. It is clearly not real estate, yet.

Improvement Exchange Strategy
Real property is very often bought and held by an EAT. The real property is then improved by the EAT, generally through some form of construction. The real property is then conveyed to the party completing the 1031 exchange once the improvements have been made. This 1031 exchange strategy is referred to under many names, including: Improvement Exchange or a Build-To-Suit Exchange or even a Construction Exchange.

The Improvement Exchange strategy can be structured for his proposed 1031 exchange. The installment note (loan) would be bought and held by the EAT. The EAT would "improve" the property by following through with the foreclosure. The EAT would end up holding title to real estate upon the completion of the foreclosure. The real property can then be conveyed to him and his 1031 exchange would be completed.

You really can buy an Instalalment Note as part of your 1031 exchange provided the replacement property received in the 1031 exchange is an interest in real estate.