Earnest Money Deposits in a 1031 Exchange

The acceptance of a purchase and sale agreement begins the often-winding journey towards the sale or acquisition of real property. Commonly, this agreement requires an earnest money deposit (EMD) to solidify the commitment to move forward. Can an EMD be received by an Exchangor who is interested in selling property in a 1031 exchange? Could that Exchangor utilize exchange proceeds towards the EMD for their replacement property? We’ll review a few scenarios below. 

Why is it important to be aware and intentional about how to receive funds as an Exchangor? Regardless of whether or not the earnest money deposit is refundable or non-refundable, an Exchangor should take care in receiving funds so as not to violate the g(6) limitations of constructive or actual receipt of funds.

Receiving an EMD as part of the sale of a Relinquished Property

In the common scenario where an Exchangor receives an EMD as part of the sale of their relinquished property, there are two paths forward. The first path is to have the Title Agency or Closing Attorney hold the EMD in escrow until the relinquished property closes. At this time, along with the rest of the Exchange Proceeds; the funds will be wired to the Qualified Intermediary and in doing so avoid actual or constructive receipt of funds. Generally speaking, an earnest money deposit is not taxable until the transaction has closed or the funds have been forfeited by the buyer.

If the Exchangor holds the EMD in escrow until closing and then combines the EMD with the closing funds to be sent to the QI, they will avoid taxation. The other path would be for the Exchangor to retain the EMD in a personal account and in holding the funds in that way they would be taxable. Most commonly, Exchangors combine the EMD with the additional closing funds provided by the Buyer and utilize them towards their replacement property acquisition.

Can exchange proceeds be used towards an EMD? 

The Exchangor is eligible to utilize their exchange proceeds towards their replacement property’s EMD. In this scenario, the Exchangor will need to first assign the contract to the QI via an Assignment document. Once this is complete, the QI can provide the EMD funds via wire to the appropriate party. If for whatever reason the sale falls through, the EMD funds provided should be returned directly to the QI to avoid actual or constructive receipt.

Can exchange proceeds reimburse my personal funds that I used for an EMD? 

Should the Exchangor decide to utilize their personal funds for the EMD, they are eligible to be reimbursed via exchange proceeds at the closing of the replacement property as long as there are sufficient funds. This is executed at the closing of the replacement property and requires coordination between the Closing Agent and the Qualified Intermediary. Exchange Proceeds cannot be specifically allocated so in order for the personal EMD funds to be refunded, there must be adequate funds to do so. It’s recommended to discuss this with your QI prior to providing the EMD. 

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Atlas 1031 Exchange has been accommodating tax deferred exchanges of all kinds for more than 16 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange. Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.