In a 1031 exchange, real property earnest money deposits, extension or option payments are recognized as an act of good faith of the Buyer’s intent to acquire the subject property. Following guidelines is especially important in a 1031 exchange so as not to violate the g(6) limitations of constructive receipt of the Internal Revenue Code Section 1.1031. Constructive receipt is when the taxpayer has access or possession of the funds at the time of the exchange as denoted by the closing date and the fact that property ownership has been conveyed to the Buyer. One of the primary roles of the Qualified Intermediary is to hold the earnest money deposit and exchange proceeds for the taxpayer and use them towards the replacement property purchase.
Relinquished Property Sale
When the taxpayer or exchangor sells their relinquished or old property, they will typically receive an earnest money deposit. The taxpayer has two options. The first is to hold those funds and at closing either deposit with escrow, the title company, Qualified Intermediary or keep them. Once the closing is completed and the earnest money deposit is kept, the earnest money deposit is taxable.
In a 1031 exchange, if the goal is to defer 100 percent of the realized gain, then the net equity plus the debt retired must be replaced in the new property. If this is not the intent, then the best time to receive cash is at the closing in what is referred to as a partial 1031 exchange. Whenever the replacement property is 50 to 60 percent of the relinquished property, it probably does not make sense to initiate a 1031 exchange. The tax on the 50 to 40 percent will be close to the tax that would be paid if a 1031 exchange is not initiated.
Replacement Property Purchase
In a 1031 exchange, the taxpayer will acquire replacement property and place an earnest money deposit with escrow or title company. The funds can come from the taxpayer or wired from the exchange proceeds. If adequate exchange funds are available, the earnest money deposit can also be reimbursed at closing given the taxpayer made the deposit with non-exchange proceeds. Should exchange funds be used to provide the earnest money deposit, the taxpayer must sign an Assignment of the Purchase and Sale Agreement with the Qualified Intermediary prior to the disbursement. If the sale were to fall through and the earnest money deposit was provided from exchange proceeds, then the earnest money deposit should be returned to the Qualified Intermediary to avoid constructive receipt.
Soft Costs
In addition to the earnest money deposit, the taxpayer may also ask for the Qualified Intermediary to make other payments associated with the replacement property purchase. Only capitalized expenses associated with the replacement property are to be paid either by the Qualified Intermediary or at closing by escrow or title company. It is best to confirm with your CPA whether the expenses are recognized as capitalized costs. These soft costs typically include architectural, appraisal, environmental and permits. If the CPA is not sure, then it is best to pay these with non-exchange fees to avoid the possibility of taxable boot. If the expenses are typically found on the closing statement, then they may be paid by the Qualified Intermediary without a taxable impact.
There are many rules to follow when initiating a 1031 exchange. Those taxpayers who take a cautious approach will help themselves avoid the potential of a taxable outcome. To learn more about 1031 exchanges, download a free “1031 Exchange Checklist” by clicking here.
