A common practice when closing the sale of an investment property is for the seller to give the buyer a credit for any security deposits held by the seller and any rent that is to be prorated between the seller and buyer. If the seller is doing a 1031 exchange, it’s important to understand how those credits will affect the seller’s exchange.
Since prorated rents and security deposits are not “exchange expenses,” using exchange funds to pay these will cause the transaction to be partially taxable. Giving the buyer a credit for these is equivalent to using exchange funds to pay them, because the seller is able to use sale proceeds to pay them and the exchange ends up with less money to use to buy replacement property.
For example, if you are selling property for $5 million and you owe the buyer $100,000 in prorated rents and security deposits, you would typically give the buyer a credit for these and the buyer would pay you $4.9 million instead of $5 million (ignoring other costs). The closing agent would send the $4.9 million to First American Exchange to use to acquire the replacement property. Since the total exchange funds were $5 million but only $4.9 million is available to acquire the replacement property, the transaction will be taxable to the extent of the $100,000 that was not used to acquire replacement property.
Using exchange funds to pay prorated rents and security deposits shouldn’t ruin an exchange but will create taxable boot. You can choose to either come up with your own funds to pay these expenses if you have available funds and want to avoid boot, or give the buyer a credit at the closing, in which case it will be partially taxable.
It is a good idea to have your tax advisor review the numbers on the closing statement prior to closing. That will ensure that you have a good idea of the net proceeds you will be working with when acquiring replacement property and whether you will have a fully tax-deferred exchange.