When purchasing real estate, buyers typically include an earnest money deposit with their offer to the seller. The deposit may be refundable or non-refundable, depending on the conditions of the purchase agreement. In general, the delivery of the deposit serves as evidence of the buyer’s intention to buy the property and is usually refundable. However, for a myriad of reasons, buyers will sometime authorize release of the earnest money deposit to the seller, also known as a “non-refundable” deposit or “early release.”
In a tax-deferred exchange under Internal Revenue Code Section 1031, the seller/taxpayer is prohibited from receiving the proceeds from the sale of a relinquished property. A taxpayer is “in receipt” of sale proceeds if: “…the taxpayer actually receives the money or property or receives the economic benefit of the money or property. The taxpayer is in constructive receipt of money or property at the time the money or property is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon it at any time or so that the taxpayer can draw upon it if notice of intention to draw is given.”
The aforementioned regulations have caused taxpayers to be justifiably worried about the tax implications that may arise from receiving a non-refundable deposit from a buyer or providing a deposit to a seller for the procurement of a replacement property. Here are some frequently asked questions regarding the management of deposits in an exchange:
If a taxpayer who is selling an investment property intends to participate in a 1031 exchange, can they accept a non-refundable deposit while still being eligible for complete tax deferral? Typically, the answer is yes. The determination of whether the taxpayer has received sale proceeds is usually made at the time of transfer of ownership from the seller to the buyer, which commonly happens during the closing process. Therefore, if the taxpayer enters into a 1031 exchange agreement before the closing and then places the earnest money funds with the qualified intermediary (QI) before the closing takes place, the receipt of the deposit should not be treated as the receipt of sale proceeds. However, if the taxpayer retains the deposit at closing, it would be regarded as sale proceeds. As a result, the deposit would be treated as boot in the exchange and taxed to the extent of any capital gain.
Can funds from a non-refundable deposit be utilized by the QI to pay for a deposit on the replacement property? Yes, the QI has the ability to provide funds for the deposit after the exchange documents have assigned the QI as the purchaser of the replacement property. This is also the case where the QI has received closing funds from the sale of the relinquished property.
Is it permissible for the taxpayer to sign a contract for a replacement property before signing one for their relinquished property? Yes, but it is crucial to close the transaction for the relinquished property before acquiring the replacement property to prevent a situation that would require a reverse exchange parking arrangement.
Is it possible for a taxpayer to get their deposit back for a replacement property? While a QI is not allowed to directly reimburse the taxpayer for the deposit, they can provide exchange proceeds to replace the deposit held by the closing agent, which can be reimbursed to the taxpayer during the closing process.
As each situation is unique, exchangers should always seek the guidance of an attorney or tax advisor.
If you or someone you know has questions about the 1031 exchange process, our team of experts at Peak 1031 Exchange are here to help. Contact us today at [email protected] or by calling us at 818-960-7019 to discuss the deferral of capital gains taxes with a 1031 exchange.