1031 Tax Free Exchange - Earnest Money Deposit

In real estate transactions, the parties use closing statements, or escrow agreements, to memorialize purchase-and-sales agreement terms.

The closing statement's focus is the price, but the contract can stipulate other items such as prorated rents and property taxes, escrow account buyouts, security deposit transfers, or prepaid service contract reimbursements that the settlement statement commonly reflects.

Typically the settlement statement also shows closing costs such as attorneys' fees, real estate commissions, or transfer taxes associated with the sale. Items shown as a cost to the seller become a debit on the settlement statement and reduce the amount of proceeds available after the sale.

In exchanges, settlement statement costs to the seller reduce exchange proceeds. In addition, the IRS treats non-allowable exchange expenses charged to the seller as taxable items. Some of the more common non-allowable exchange items include prorated rents, security deposit transfers, and loan fees. For example, a relinquished property is a rental building with an existing tenant, and the contract stipulates that the seller transfer the security deposit to the new owner.

In this situation, the IRS does not consider the security deposit a closing cost; it simply is an additional business item that happens to be associated with the sales contract. However, if the settlement statement charges the security deposit amount against the seller, the debit reduces the exchange proceeds amount. The seller probably delineates this reduction on his 8824 exchange reporting form, which requires him to pay taxes on the amount. As this example demonstrates, sellers should strive to minimize non-allowable exchange expenses during 1031 exchange closings.

Resolving Closing Statement Questions

To fix non-allowable exchange items simply, the seller should show them as paid outside closing, or POC, on the settlement statement and give the buyer a separate check. By following this procedure, these non-allowable items don't reduce proceeds and don't trigger taxable gain.

For example, Jerry is selling a $750,000 single-tenant-leased building. The closing is taking place mid-month, and the contract calls for security deposit transfer and rent proration. Jerry holds a $15,000 security deposit and $10,000 in prorated rent for the balance of the month, as well as a $7,500 earnest money deposit.

Jerry seeks advice from a 1031 professional service provider on how to minimize his tax consequences during the transaction. The tax adviser instructs the closing attorney to list the security deposit transfer and prorated rents as POC. At the closing, Jerry writes a check made payable to the buyer for $25,000 (the security deposit and prorated rent) and a check made payable to the closing attorney for $7,500 (the earnest money refund). By handling the designated non-allowable closing items and the earnest money in this fashion, Jerry ensures that his exchange transaction triggers no tax.

The appropriate handlings of earnest money and closing statements are only two of the potential complications during 1031 tax-deferred exchanges. Individuals not familiar with 1031 exchange complexities should seek qualified advice from a tax professional to achieve the desired economic benefits. Otherwise, supposed tax-free exchange transactions may leave sellers with surprise tax bills.