Completing a 1031 exchange is a common way for real estate investors to defer capital gains taxes from the sale of investment properties.
In an exchange, investors replace their divested real property with like-kind replacement assets. One important rule about 1031 exchanges is that sellers can’t handle funds in 1031 exchange transactions – they must engage a third-party qualified intermediary to facilitate monetary transactions since the Internal Revenue Service prohibits taxpayers from taking constructive receipt of funds during the exchange process.
That caveat brings up an important question about 1031 exchanges – how is earnest money treated when selling relinquished assets and purchasing replacement properties? In this article, we’ll take a closer look at how earnest money should be treated on both sides of 1031 exchange transactions.
Earnest Money and Relinquished Assets in a 1031 Exchange
In standard real estate transactions between buyers and sellers, buyers are often required to place deposits on properties to show good faith that they intend to secure the funds necessary to complete the purchase. This earnest money is usually required once both parties enter into a legally binding purchase agreement.
Depending on the terms of the purchase agreement, that earnest money is held either by a title company, commercial brokerage, or even by the seller. For 1031 exchangers, earnest money placed as a deposit on their relinquished assets should always be held by a third party, such as a qualified intermediary, attorney, broker, or other agent, since exchangers cannot take receipt of funds at any time during the exchange process.
When it comes time to close the deal, earnest money can be transferred to the closing agent, who will deliver those proceeds to the exchange facilitator to complete the sale of the relinquished asset. This may be a circuitous route for handling earnest money deposits, but it’s a safe course since it guarantees exchangers don’t handle any funds during the sale of their relinquished assets.
Earnest Money and Replacement Assets in a 1031 Exchange
When it’s time to secure replacement assets, exchangers flip roles and may be required to place earnest money deposits to secure their replacement properties once they enter into purchase agreements.
Exchangers have two options for handling earnest money deposits:
- They can pay this money directly to the seller if they choose – funds can be added to a 1031 exchange transaction without creating any tax or regulatory complications. The exchanger can even have those funds returned at closing if there is sufficient capital from the relinquished asset to complete the purchase of the replacement asset.
- Exchangers who want to use funds from their relinquished assets can have their qualified intermediary place earnest money deposits on replacement properties. In order to do so, however, the purchase agreement must be assigned to the QI. It should also be clear that any refundable earnest money will be returned to the exchange facilitator if the deal somehow falls through so that the exchanger never directly handles any funds.
Putting it all Together
One of the many unbreakable rules associated with 1031 exchanges is constructive receipt of funds – exchangers can’t handle any money from the sale or purchase of properties involved in either side of 1031 exchanges.
If an exchanger took receipt of earnest money given as a deposit on a relinquished asset and kept those funds through the closing process, it would create a taxable event from boot generated in the sale. The safest route is to always have earnest money assigned to a third party. On the other side, exchangers can use proceeds from relinquished assets as earnest money deposits on replacement assets as long as a purchase agreement has been assigned to their qualified intermediary.
With proper documentation and planning, earnest money in 1031 exchange transactions can be handled properly without creating any tax consequences.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
