(Note: This article is the first of three reprinted with the permission of the American Federation of Exchange Accommodators. All three will address various issues pertaining to IRS Section 1031 tax deferred exchanges).

When buying or selling property as part of a tax-free exchange, it is customary for the buyer to put down an earnest money deposit to hold the property. How should this deposit be handled to avoid treatment as taxable boot in the exchange?

Selling Relinquished Property. When selling relinquished property in an exchange, avoid actual or constructive receipt of the earnest money deposit. Most earnest money is deposited with an escrow agent or realtor, and if there are no conditions to the seller’s actually receiving the earnest money deposit (such as due diligence review or receipt of a deed from the seller), the funds will be deemed constructively received by the taxpayer.

For example, in Michael Hillyer v. Commissioner, 69 TCM (RIA) ¶ 96,214, at 1565 (1996), the funds were found taxable when the proceeds were held by the escrow agent "for the direction of the [seller] in the acquisition of replacement properties." See also Maxwell v. U.S., 88-2 USTC (CCH) ¶ 9560 (SD Fla 1988); PLR 9052019 (Sept. 28, 1990).

Another issue relates to the assignment of the earnest money for the sale of the relinquished property. The assignment to the accommodator of the agreement to sell the relinquished property should clearly provide that the assignment includes the earnest. Otherwise, it will clearly be taxable as boot since at closing the taxpayer would be entitled to receive the benefit of the earnest money.

Purchasing Replacement Property. The situation is more complicated if the taxpayer or the accommodator makes an earnest money deposit to purchase replacement property.

If the taxpayer makes the earnest money deposit to purchase the replacement property, there generally will not be a problem with boot. Will the taxpayer have boot income if the taxpayer wants to receive back the cash at the closing of the purchase of the replacement property? Probably not. The rule appears to be that a taxpayer need not recognize boot received to the extent of cash boot given as part of the same closing. See Rev Rul 72-456, 1972-2 CB 468.

This rule might not work if the accommodator is going to temporarily hold the replacement property and later transfer the replacement property to the taxpayer, as would be the case in an improvement exchange. In such a situation, the taxpayer is actually receiving boot in the form of exchange proceeds, but not as a part of the closing to acquire the replacement property. No funds should be transferred to the taxpayer unless it is after an approval cash-out event under Treas Reg § 1.1031(k)-(g)(6). It might be possible to argue that the taxpayer merely lent the earnest money funds to the accommodator who was paying back the loan on closing the purchase of the replacement property. For example, PLR 9149018 (Sept. 4, 1991) approved a taxpayer acting as both a lender and an exchanging party in a tax-free exchange.

If the accommodator is to pay earnest money to the seller, either the accommodator must be the purchaser under the purchase agreement or the purchase agreement must be assigned to the accommodator as the buyer. If the accommodator is not the buyer, the taxpayer will have taxable boot because the accommodator is essentially allowing the taxpayer to withdraw exchange proceeds before the exchange has closed in violation of Treas Reg § 1.1031(k)-1(g)(6).

Another important issue is whether the assignment has been properly drawn if its purpose is to allow the accommodator to pay earnest money to purchase the replacement property. Many assignment forms provide that the assignment is effective on closing of the purchase of the replacement property. Obviously, such an assignment would not be immediately effective and would allow the IRS to argue that since the assignment was not immediately effective, the taxpayer had received taxable boot because the exchange funds were paid for his benefit.

Conclusion. To avoid boot with respect to the receipt or payment of earnest money, there are a few easy rules to remember. Earnest money to sell relinquished property should be deposited with an escrow agent under escrow instructions that do not give the taxpayer the right to direct how and when the funds are to be used. The earnest money should be assigned to the accommodator as part of the closing. Earnest money to purchase replacement property can be reimbursed to the taxpayer as part of a closing. If the accommodator is to pay out the earnest money, it may do so only if the accommodator is the purchaser of the replacement property under a purchase agreement or if the purchase agreement has been assigned to it.