Manage exchange transactions precisely to maximize tax benefits
Internal Revenue Code Section
1031 tax-deferred exchanges may look similar to simple property
acquisitions in which the buyer uses funds from a previous building
sale. However, these transactions entail specific closing details that
differ from traditional real estate sales. Relinquished property
sellers must handle earnest money and certain closing expenses properly
to maximize exchange transactions' tax benefits.
Refunding Earnest Money
During most real estate sales, prospective buyers offer sellers earnest
money as a down payment toward the final transaction. During 1031
exchanges many sellers want to know if they can hold the earnest money.
The answer is absolutely. The Internal Revenue Service does not
prohibit taxpayers from holding earnest money when executing exchange
transactions, yet certain rules apply.
the closing takes place, the earnest money deposit becomes proceeds. If
the relinquished property seller possesses the earnest money after
closing, the IRS considers the deposit taxable proceeds. To avoid this,
the seller should refund the earnest money to the closing. The seller
incurs no gain as long as he refunds the deposit amount.
problems don't arise if a real estate company or title/escrow company
holds the earnest money. In that situation, the company forwards the
earnest money to the closing or retains it to real estate commission,
which is an allowable exchange expense.
Closing Statement Issues
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.
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.
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
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
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.
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.