Purchasing Notes as Replacement Property in a 1031 Exchange
A 1031 exchange allows real estate investors to defer capital gains taxes by reinvesting proceeds from the sale of one property into another property of “like kind.” While many investors focus on traditional replacement properties such as multifamily, retail, or industrial real estate, some consider whether a promissory note or other debt instrument could qualify as replacement property. Understanding the IRS rules on this subject is essential before attempting such a strategy.
Are Promissory Notes “Like-Kind” to Real Estate?
The Internal Revenue Code is clear that, in order for a replacement property to qualify under Section 1031, it must be considered real property. According to Treasury Regulations §1.1031(a)-3, “real property” generally includes land and improvements, as well as certain natural resources, water rights, and interests in real estate such as fee ownership, leasehold interests of 30 years or more, and easements.
Promissory notes or mortgages, by contrast, are classified as personal property, not real property. The IRS has consistently ruled that notes represent a right to receive income rather than an ownership interest in real estate. Because of this classification, promissory notes are not “like kind” to real property and therefore do not qualify as valid replacement property in a 1031 exchange.
Why Investors Sometimes Ask About Notes
Questions about using promissory notes often arise because of the unique ways real estate transactions can be structured. For example:
A seller may “carry back” financing when selling a property, creating a promissory note payable by the buyer.
Investors might consider purchasing an existing mortgage note secured by real estate.
Some may wonder whether converting cash from an exchange into a note would meet IRS requirements.
In all of these cases, however, the IRS position remains the same: notes, even if secured by real estate, are not real property and cannot serve as replacement property for 1031 purposes.
Treatment of Notes in 1031 Exchanges
While promissory notes cannot be used as replacement property, they can appear on the relinquished property side of a 1031 transaction. For example:
If a seller receives a note as part of the consideration for the sale of the relinquished property, that portion is treated as “boot”—non-like-kind property received in the exchange.
Boot is taxable to the extent of recognized gain, which means the investor may owe capital gains tax on the value of the note received.
To maintain full tax deferral, investors generally avoid receiving notes in exchange for their relinquished property, or they structure the transaction so that cash, not notes, flows through the qualified intermediary to the replacement property.
While promissory notes may play a role in broader real estate investing, they cannot be substituted for real property in a 1031 exchange. Investors considering creative financing or unconventional exchange structures should proceed cautiously and review the IRS rules carefully. Consultation with tax advisors and qualified intermediaries is strongly recommended to ensure compliance and avoid unintended tax consequences.
