Frequently Asked Questions on IRC 1031 Replacement Property Contract Deposits

Written By Diane Schaefer, CES™ and President of Exchange Solutions, Inc., N.Y.

Frequently the taxpayer will want the qualified intermediary (QI) to make an earnest money or contract deposit on the replacement property with the exchange funds being held by the QI from the sale of the relinquished property. Payments can be made and qualify for the exchange as long as “the (g)(6) limitations” (Reg. Section 1.1031(k)-1(g)(6)) are not violated wherein a taxpayer’s rights to receive, pledge, borrow or otherwise obtain the benefits of the cash held by the QI are extremely limited.

Once the taxpayer and the seller of the replacement property execute the purchase contract, an assignment of the incidence of ownership is conveyed by the taxpayer to the QI, as purchaser.  The QI can now advance the contract deposit on the replacement property. This will prevent the taxpayer from constructively receiving the funds and tainting the exchange.

What if the taxpayer found replacement property and wants to put down an earnest money or contract deposit prior to the relinquished property closing? Can the taxpayer recoup this deposit without triggering a taxable event after the relinquished property is sold and funds have been deposited with the QI?

We often see this scenario, especially with the current conditions in the real estate market. This can be accomplished by choosing one of three options as long as the taxpayer is abiding by “the (g)(6) limitations” and the exchange is structured carefully.  Three approaches to refunding a taxpayer’s contract deposit with ancillary funds before the QI has the exchange proceeds from the sale of the relinquished property are as follows: 1) Refund the taxpayer prior to the replacement property closing; 2) refund the taxpayer at the replacement property closing or 3) refund the taxpayer after the closing.

The first option allows the taxpayer to obtain their own cash back prior to closing on the replacement property as long as all parties to the closing are in agreement and willing to cooperate. Subsequent to the sale closing of the relinquished property, exchange funds are deposited and cleared with the QI. The QI is assigned the incidence of ownership on the replacement property contract executed by the taxpayer and seller at a previous date. The QI uses the exchange funds to initiate a second contract deposit to the seller’s attorney’s escrow account. The seller’s attorney can now refund the initial contract deposit directly back to the taxpayer prior to closing on the replacement property.

The second approach would be handled in the same manner as the first option, however, the QI would release the full purchase price, including the contract deposit, at time of closing for the replacement property.  Again, the seller’s attorney can reimburse the taxpayer’s cash out of pocket at the closing.

Lastly, the QI can reimburse the taxpayer directly. If the taxpayer funds the contract deposit directly to the seller’s attorney’s escrow account with ancillary funds, the taxpayer cannot be reimbursed by the QI until after the 45-day identification period has expired and after the closing of the last replacement property.  However, it is most seamless for the seller’s attorney to reimburse the taxpayer directly.

These methods will be successful only if the QI has sufficient funds to acquire the replacement property and the taxpayer does not need to advance additional proceeds for the acquisition of the replacement property.

We encourage our clients to communicate their intentions to us prior to delivery of any personal funds in an exchange. If not structured correctly, the taxpayer could possibly create a taxable event.

It is most important that a taxpayer always consult with a tax advisor while engaging in a tax-deferred exchange and inquire when payments made by the QI will and will not jeopardize the exchange.