Why installment notes are boot in a 1031 exchange
In a 1031 exchange, you must receive only like-kind property in exchange for your relinquished property. If you also receive money or other property — anything that is not like-kind real estate — the excess is called boot and is taxable.
An installment note (seller financing) is a promise to pay money in the future. The IRS treats a note received from the buyer as money or other property — it is not like-kind real estate — so it counts as boot in the exchange. If the buyer pays $600,000 for your property and puts down $500,000 in cash (which goes to the QI) plus a $100,000 installment note, the $100,000 note is boot and the gain allocated to that boot is taxable in the year of the exchange.
Why you can't defer using the installment sale method
You might think: if the note is taxable, I can at least spread the gain using installment sale rules (Section 453). Unfortunately, Section 453(i) specifically requires all depreciation recapture to be recognized in the year of sale, even in an installment arrangement. And more importantly, you cannot combine installment sale deferral with 1031 exchange deferral for the same note — the installment method applies when a transaction doesn't qualify as a 1031 exchange for a particular dollar amount.
However, there is a planning approach: some practitioners have structured exchanges where the QI holds the installment note (rather than distributing it to the exchanger) and exchanges the note itself, under specific IRS guidance. This is complex and requires careful execution. Most straightforward cases simply treat the note as taxable boot.
Practical tips if your buyer needs seller financing
If your buyer needs seller financing to close, and you want to complete a full 1031 exchange, consider these alternatives: (1) have the buyer obtain a third-party loan for the full amount, (2) negotiate a purchase-money mortgage that is paid off at closing, or (3) if you cannot avoid the note, accept that the note amount is boot and plan for the tax on that portion.
Also note that debt relief is also boot. If your relinquished property had a mortgage that the buyer assumes, and your replacement property has a smaller or no mortgage, the net debt reduction counts as boot as well. Run the full boot calculation — cash boot plus mortgage boot plus any note — before finalizing your exchange structure.
A worked example: cash plus a carryback note
Suppose you sell a rental for $700,000. The buyer pays $550,000 in cash (wired to your qualified intermediary) and gives you a $150,000 seller-financed note payable over five years. Your adjusted basis is $300,000, so your realized gain is $400,000. You use the full $550,000 of cash to buy a like-kind replacement property. The $150,000 note, however, is boot — it never went to the QI as like-kind consideration. You therefore recognize gain equal to the boot: $150,000 is taxable in the year of the exchange, while the remaining $250,000 of gain is deferred into the replacement property's carryover basis.
The lesson is that carrying paper does not simply defer the note's own gain — it converts that slice of your exchange into an immediately taxable event, and the tax is due even though the buyer pays you the principal over five years unless you can layer in the installment method described below.
The recapture-first ordering rule on the boot
When boot forces you to recognize gain in an exchange, the tax code does not let you treat that gain as favorable capital gain first. Under the recapture rules, depreciation recapture is recognized before capital gain. So if your $150,000 of note boot is backed by, say, $120,000 of pending unrecaptured Section 1250 gain, that $120,000 is taxed at up to the 25% rate first, and only the remaining $30,000 gets long-term capital gain treatment. If any of your depreciation sat in Section 1245 personal property from a cost segregation study, that portion recaptures at ordinary income rates and comes out even earlier. The practical consequence: the first dollars you are forced to recognize from carrying a note are usually your highest-taxed dollars, which makes seller financing inside an exchange more expensive than the note amount alone suggests.
Understanding the full boot stack
A note is only one of three kinds of boot, and they interact. Cash boot is any exchange proceeds you actually pocket. Mortgage (debt-relief) boot arises when the debt on your replacement property is less than the debt on the relinquished property. Note boot is the seller-financed installment note. The rules let you net some of these: additional cash you bring to the closing table on the replacement side can offset mortgage boot, for example. But cash and notes received generally cannot be offset by taking on more debt. Before you agree to carry paper, run the complete boot calculation across all three categories so you know your true recognized gain — a common mistake is to fix the mortgage-boot problem while forgetting that the note itself is still fully taxable boot on top of it.
Using the installment method if the note is taxable
If you accept that the note is boot, you may still be able to spread the resulting gain using the installment method under Section 453, reporting the note's gain as principal payments are received rather than all at once. You would report this on Form 6252. Two important limits apply. First, Section 453(i) requires all depreciation recapture to be recognized in the year of sale, no matter how slowly the note is paid — you cannot spread the recapture portion. Second, the installment method covers only the note's own gain; it does not create additional 1031 deferral. In effect, the cash-and-replacement portion is handled by the exchange, and the note portion is handled (partly) by the installment method — two separate deferral regimes stitched together on the same transaction.
The QI-holds-the-note structure, in detail
The cleanest way to avoid note boot is to keep the note out of your hands. In this structure, the installment note is made payable to the qualified intermediary rather than to you, so it becomes part of the exchange proceeds the QI holds. The QI can then either sell the note to a third party for cash and use that cash toward your replacement property, or the buyer can pay off the note quickly so the QI receives cash within the exchange period. Because you never had the right to receive the note directly, it is not treated as boot to you. This works, but it is technical: it requires the exchange documents to route the note to the QI from the outset, a QI willing to hold or dispose of paper, and often a note buyer lined up in advance. Have a 1031-experienced attorney structure it — retroactively fixing a note already made payable to you generally does not work.
How it is reported
Every 1031 exchange is reported on Form 8824, which computes your realized gain, the recognized gain from any boot (including the note), and the replacement property's carryover basis. Gain recognized because of boot flows to Form 4797, where the recapture-first ordering is applied. If you elect the installment method for the note's gain, that piece is tracked on Form 6252 and carried each year until the note is paid off. Keep the closing statement, the note itself, and your Form 8824 together — the note's tax basis and remaining deferred gain depend on figures established in the year of the exchange, and you will need them every year you collect on the note.
The interest on the note is separate, ordinary income
Two dollars flow to you from a seller-financed note, and they are taxed very differently. The principal payments return your capital and the gain (handled by the exchange and any installment-method treatment above). The interest the buyer pays on the note is ordinary income, reported on Schedule B, completely separate from the boot and gain analysis. You cannot defer or 1031 the interest — it is simply taxable each year as received. There is also a trap for below-market notes: if the stated interest rate is too low, the imputed interest and original issue discount rules require you to treat part of what looks like principal as interest, using the IRS applicable federal rate (AFR) in effect for the note's term. Charge at least the AFR to avoid having the IRS re-characterize your principal as additional ordinary interest income.
Frequently asked questions
Is a seller-financed note always boot in a 1031 exchange?
Yes, under standard IRS rules. An installment note is treated as other property (not like-kind real estate) and is therefore taxable boot in the exchange.
Can I avoid the boot if the QI holds the note?
Some practitioners structure exchanges where the QI holds the note as part of the exchange proceeds. This is complex and should be handled by an attorney with 1031 exchange experience.
What if the note amount is smaller than my realized gain?
You recognize gain only up to the amount of boot received. If the note is $50,000 and your total gain is $200,000, you recognize $50,000 now and defer $150,000 in the exchange.
Can I spread the note's gain over the years the buyer pays me?
Often yes, using the installment method under Section 453 on Form 6252 — but Section 453(i) still forces all depreciation recapture to be recognized in the year of sale, and the installment method applies only to the note's own gain, not the exchanged portion.
Is the note taxed at capital gains rates?
Not entirely. The recapture-first rule recognizes depreciation recapture before capital gain, so the initial dollars of gain on the boot are taxed at the higher unrecaptured Section 1250 rate (up to 25%), or ordinary rates for any Section 1245 component, before any long-term capital gain rate applies.
Which forms report a seller-financed note in a 1031 exchange?
Form 8824 reports the exchange and computes recognized gain from boot; Form 4797 handles the recapture ordering on that recognized gain; and Form 6252 tracks the note if you elect the installment method.
Sources
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.