Seller Financing and 1031 Exchanges: A Guide for Buyers and Sellers

What is Seller Financing? 

Seller financing is a real estate arrangement wherein the Seller acts as the lender by offering a loan directly to the Buyer. While traditionally done through a bank or mortgage company, in seller financing, the Buyer instead repays the Seller over time in regular installments plus interest.

How Seller Financing Differs from Traditional Bank Loans 

Compared to traditional bank loans, seller financing offers more flexibility. Where bank loans require rigorous inspections, formal appraisals, lower loans to value and a stronger credit rating, seller financing does not. Instead, seller financing allows the Seller and Buyer to bypass these requirements. This ultimately expedites the closing process and saves costs. While title traditionally transfers to the Buyer at closing, some seller-financed deals, specifically land contracts, may delay this transfer until the Buyer has repaid the Seller’s loan in full.  

Rather than using the standard bank-issued documents, seller-financed transactions are customized agreements between the Buyer and Seller.  This is often done by promissory note and a deed of trust/mortgage or by land contract, which are typically drafted by an experienced real estate attorney and without the involvement of an institutional third party.

Seller Financing: A Timely Strategy for All 

Mortgage rates have been on the rise since mid-2021, now at an average of nearly 5% for a 30-year fixed-rate mortgage with 20% down and a credit score of 630. This makes it significantly harder for Buyers to qualify for traditional financing. Thus, seller financing came about as a strategic solution for Buyers and Sellers in this high-interest-rate environment. As institutional lending becomes more restrictive and borrowing costs increase, seller financing affords Buyers more opportunities while simultaneously allowing Sellers to stay competitive in a slower, more selective market. 

Motivations of Seller Financing for Sellers 

Sellers are more motivated to utilize seller financing in their transactions. Sellers are able to reach a larger pool of Buyers by offering the more flexible seller financing option.  This broadens a Seller’s options significantly by including Buyers who would normally be barred from purchasing property under a traditional mortgage. Through seller financing, the sales process is significantly expedited, allowing you to bypass institutional steps like bank processing, underwriting, and loan approvals. Furthermore, Sellers are able to earn interest on their loan over time and report it annually as regular income, rather than the traditional way of receiving a single, lump-sum payment from the sale of their properties. This can, in the long run, lead to a higher overall return compared to a traditional sale. Sellers may be allowed to defer capital gains taxes over several years through the use of a loan with consistent installment payments instead of paying the full tax liability in the year of the sale.

Motivations of Seller Financing for Buyers 

Buyers also benefit greatly from Seller Financing, making those properties more attractive than others on the market. In a market facing high mortgage rates, many prospective Buyers struggle to meet traditional lending requirements, whether that be due to low credit scores, irregular income, or coming up short on a down payment. Seller Financing allows the property owner to set their own qualifying criteria for Buyers, attracting a larger group of potential Buyers.  

Given that the Seller acts as the lender, the timeline for closing can be significantly shortened. Without the traditional delays of appraisals, bank underwriting, and other lender requirements, Buyers often close and receive their keys in a fraction of the standard 30 to 60-day timeframe. Without lender involvement, this streamlined process can also reduce costs for Buyers. Fees typically involved in a standard loan, such as origination and processing, can be avoided. Moreover, properties that may not meet traditional lender criteria, such as properties that require significant improvements, including structural issues (foundational problems, leaks, mold), code violations (zoning violations, unpermitted construction), and environmental factors (flood zones, landfill proximity) can still be purchased under Seller-Financed terms, allowing Buyers access to a broader and more diverse selection of real estate.  

Seller Financing in a 1031 Exchange 

Seller Financing plays a strategic role in structuring a 1031 Exchange. Here’s a real-world scenario where a 1031 Exchange transaction successfully utilizes Seller Financing. 

A property owner is selling an investment property for $300,000 as part of a 1031 Exchange and agrees to finance $200,000 of the purchase price for the Buyer. This allows the Buyer to avoid traditional bank financing and makes the deal more attractive or feasible. At closing, the Seller/Exchanger receives only $100,000 in cash, with the remaining $200,000 secured as a promissory note from the Buyer. For the purposes of the 1031 Exchange, only the $100,000 in cash can be transferred into the exchange account. The $200,000 in seller-financed proceeds is not immediately eligible for reinvestment and would generally be treated as "boot".

To avoid immediate taxation on the financed amount and qualify for full tax deferral, the Exchanger must “buy back” the $200,000 note by contributing that same amount in new cash to the exchange account. This step ensures that the entire $300,000 is reinvested, satisfying IRC §1031 requirements. In essence, the Exchanger must advance the value of the property being sold into the new property, while receiving the purchase price itself over time. 

While this structure requires the Exchanger to have additional cash available up front, it offers several potential benefits. The Seller can maintain control over the financing terms and collect income on interest from the Buyer, often at a rate higher than standard fixed-income investments would earn. At the same time, by reinvesting the full proceeds, including the portion originally financed, the Exchanger preserves their ability to defer associated taxes and achieves a successful 1031 Exchange. Once the 1031 Exchange is complete there is no further reporting necessary for the Seller Financing repayment in relation to the 1031 transaction.   

Seller Financing is a significantly versatile and mutually beneficial tool to use in real estate transactions. It addresses challenges for both Sellers and Buyers while simultaneously enhancing transactional efficiency. Whether simplifying the path to ownership, unlocking tax advantages when used within a 1031 Exchange, or broadening the scope of eligible properties, Seller Financing aids in unparalleled flexibility.

1031 Asset Solutions has dedicated specialist to help with your Seller Financing and 1031 Exchange inquiries. Give us a call today at 844-401-1031.