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Earnest Money Deposits, Extension and/or Option Payments Released to Investor Before Closing of Relinquished Property Sale

Purchase and Sale Contracts ("Sale Contracts") often contain provisions or clauses that provide for the early release (payment) of earnest money deposits, extension payments, option payments or other funds before the close of the relinquished property sale transaction.

Taxable Boot

Early releases of earnest money deposits, extension payments, option payments or other funds prior to the closing of the relinquished property sale transaction are common, acceptable and often preferred by the Investor (Seller).  Buyers use these payments as strategic tools to encourage Investors (Seller) to sell, to delay the close of the sale transaction or to obtain other concessions from the Investor (Seller).

However, these early release payments can result in taxable boot to the Investor (Seller) even when the transaction has been structured as a tax-deferred exchange if the early release (payment) has not  been structured appropriately.

How the release of the earnest money deposit, extension payment, or option payment is administered depends on the goals and objectives of the Investor (Seller) and the current status of the relinquished property sale transaction.  The more important issue is whether the funds are released (paid) to the Investor or to the Investor's Qualified Intermediary as part of his tax-deferred exchange transaction.

Lack of Guidance from IRS and Treasury

Like many areas within the tax-deferred exchange industry, there has been little substantive guidance issued by the Internal Revenue Service, the Department of the Treasury and our judicial court system, which always creates challenges for the Investor (Seller) when attempting to structure a tax-deferred exchange pursuant to a Sales Contract with early release (payment) of funds provisions.

Investors should always consult with their legal and income tax advisors as well as their Qualified Intermediary before accepting or receiving any early release of funds prior to the close of their relinquished property sale transaction unless the Qualified Intermediary has been assigned into the relinquished property sale transaction and the funds are being released directly to the Qualified Intermediary as part of the Investor's tax-deferred exchange.

Potential Strategies and/or Solutions

Disbursement Directly to Qualified Intermediary

The best and most appropriate structure for an early release of funds from the relinquished property sale transaction is to ensure that Exeter 1031 Exchange Services, LLC, as the Investor's Qualified Intermediary (Accommodator), has been assigned into the Sale Contract and any applicable escrow or closing instructions prior to the early release disbursement (payment). 

The early release disbursement (payment) would then be made directly to Exeter 1031 Exchange Services, LLC as part of the Investor's tax-exchange transaction.  This transactional structure will ensure that the early release disbursment (payment) will be part of the Investor's tax-deferred exchange transaction and will not result in taxable boot.

Disbursement Directly to Investor (Seller)

Early release disbursements (payments) are frequently made directly to the Investor (Seller) before any discussion regarding a tax-deferred exchange transaction has been brought up.  When the early release disbursement (payment) has already been made to the Investor (Seller) the Investor (Seller) has two (2) options available. 

The Investor (Seller) could keep the early release disbursement (payment) as taxable boot.  Or, the Investor could deposit the early release funds back into the relinquished property sale transaction before the transaction closes, then have the Qualified Intermediary assigned into the transaction, and then have the early release funds forwarded to the Qualified Intermediary.

Investors should keep in mind that barring any substantive rulings from the Internal Revenue Service, Department of the Treasury or our judicial court system, there will always be a degree of risk with this structure.  The service could take the position that since the Investor actually received the early release disbursement (payment) and not the Qualified Intermediary the early release disbursement (payment) is a taxable distribution from the sale of the relinquished property sale transaction.

 

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