Using 1031 Exchange Funds for Earnest Money Deposits (EMD)

When utilizing exchange funds for a contract deposit on a 1031 replacement property, also known as an earnest money deposit (EMD), Legal 1031 Exchange Services must first be assigned into the purchase transaction. This requires the proper execution of replacement property exchange documents prepared by our team. To facilitate this process, we need either a signed purchase agreement or, at minimum, a draft agreement.

This may hit a hurdle where a buyer needs to provide a deposit in order to negotiate and secure a signed purchase agreement, yet the signed agreement is required in order to assign into the transaction, allowing the Legal 1031 to send the funds to escrow. A 1031 exchange “chicken or the egg” paradox.

To address this issue, exchangers have two options when using 1031 exchange funds for a contract deposit:

Option 1: Using Non-1031 Funds for the Deposit

Exchangers can use personal funds (sometimes referred to as “outside cash” or “out-of-pocket funds”) for the deposit. At closing, the QI sends in the full amount required to purchase the property (minus any mortgage, if applicable), including an amount equal to the initial deposit. This generates a credit equal to the original deposit amount, which is refunded to the exchanger at closing.

Option 2: Assigning the Contract to the Qualified Intermediary to use 1031 Funds

This can be done with the following 7 steps.

1. The exchanger provides an unsigned purchase contract to Legal 1031.
2. Legal 1031 prepares the necessary 1031 replacement property exchange documents.
3. The exchanger signs both the contract and 1031 replacement property documents.
4. The contract and 1031 exchange documents are then sent to the seller.
5. The seller signs the contract and the Notice of Assignment of Contract, then returns the signature pages along with wiring instructions to the QI.
6. Since Legal 1031 is now assigned into the transaction, we initiate the wire transfer to fund the deposit.
7. Once the seller confirms receipt of the wire transfer, the original contract and Notice of Assignment of Contract are returned.

Key Considerations for a QI Reimbursing an Exchanger’s Out-of-Pocket Deposit

If the exchanger initially funds the deposit out-of-pocket, the refund should never be sent directly to the exchanger while the 1031 exchange is still open. Best practices dictate that any reimbursement should be handled through the closing settlement process. Alternatively, after the relinquished property is sold, the QI can transfer 1031 exchange funds into escrow to replace the exchanger’s initial deposit. This allows the seller or escrow agent to reimburse the exchanger without violating 1031 exchange rules regarding actual or constructive receipt of exchange funds by the exchanging taxpayer [See Treasury Regulation §1.1031(k)-1(g)(6)].

*Important: If these procedures are not followed and a QI reimburses an exchanger directly, taxing authorities may challenge the validity of the whole exchange due to non-compliance with 1031 escrow restrictions.

Accounting & Tax Implications, Key Points and Examples

Exchangers should be mindful that both reimbursement scenarios above must occur while the exchange is still open.

From an accounting perspective:

• Receiving exchange funds from a QI after the exchange has officially closed will not qualify as a reimbursement for tax purposes—instead, it will be considered taxable “boot.”
• If improperly handled, the deposit could be treated as an out-of-pocket contribution toward the replacement property, creating “excess basis” rather than becoming deferred gain or carried basis from the relinquished property.

Ex. Scenario Option 1: Swapping 1031 funds for out for personal funds
An exchanger provides a $25,000 deposit out-of-pocket. Once Legal 1031 is in receipt of the exchange funds and is properly assigned into the transaction, we can send another $25,000 deposit to the seller or escrow agent, instructing them to release the original deposit back to the exchanger. This effectively swaps the personal funds for 1031 exchange funds while maintaining compliance.

Ex. Scenario Option 2: 1031 funds used to overfund the purchase transaction
Similar to the above example, an exchanger provides a $25,000 deposit out-of-pocket prior to starting the exchange. The exchanger engages Legal 1031 as QI and assigns us into the replacement property purchase.  At closing, the exchanger and their counsel direct Legal 1031 to overfund the closing in writing by requesting the amount needed to close, plus $25,000. They also designate a credit for the original deposit on the settlement statement. The exchanger receives a credit at closing, and 1031 funds have been swapped into the transaction. The exchanger can take their EMD back directly from the closing agent as a disbursement after closing.

Ex. Scenario Option 3: 1031 funds not correctly placed into the purchase transaction resulting in “boot”
Borrowing the same fact pattern above, an exchanger provides a $25,000 deposit out-of-pocket prior to starting the exchange. They engage Legal 1031 as QI, but do not direct us to replace the personal funds deposited in escrow or to overfund the closing. There is $25,000 leftover at the end of the exchange period and it is returned to the exchanger by Legal 1031. The exchanger has income attributable to “cash boot” because $25,000 was not used to acquire real property during the exchange. The exchanger must report this income and pay any applicable tax.

A silver lining in these situations is that the $25,000 personal cash added to the exchange may become new basis (“excess basis”) in the real estate that is eligible for depreciation.

There are a few potential options for including a contract deposit in a 1031 exchange. Taxpayers and their advisors should contact Legal 1031 in advance and work with us to avoid any of the aforementioned pitfalls.

Legal 1031 Exchange Services LLC and Legal 1031 EAT Holdings, LLC do not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of any transaction. Taxpayers must consult their tax and/or legal advisors for this information. Unless otherwise expressly indicated, any perceived federal tax advice contained in this article/communication, including attachments and enclosures, is not intended, or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any tax-related matters addressed herein. Information in this article and linked herein may not constitute the most up-to-date legal or other information. We recommend that taxpayers and their advisors independently analyze the benefits and risks of their 1031 exchange and those of related tax strategies.

Restrictions on Use: Articles, power point slides or copyrighted content in any medium including content on Legal1031.com is provided to clients, readers, users, only for limited purposes. Accordingly, you may not upload content from Legal 1031 into any; bot, chatbot, or external application, including in connection with artificial intelligence technologies, such as large language models, generative AI, or training a machine learning or AI system.

© 2021 Legal 1031 Exchange Services LLC, updated Feb. 2025.

All rights reserved. No rights claimed with respect to public domain and fair use materials contained or linked in this article.