Who Writes the Earnest Money Cheque? The Question That Quietly Creates Boot

Earnest money is one of the smallest numbers in a property transaction and one of the easiest ways to create an unnecessary tax bill.

The problem is not the deposit itself. It is what happens when exchange funds are used to reimburse you for money you paid personally, or when a deposit is returned to you rather than into the exchange.

Where does the problem come from?

In a delayed exchange, your sale proceeds are held by a Qualified Intermediary. You cannot receive them without tax consequences.

Earnest money on the replacement property is usually needed early, often before the intermediary can release funds, so buyers frequently pay it from their own account. That is fine. The issue is the accounting at closing.

If the settlement statement credits you personally for the deposit, or the intermediary reimburses you, the effect can be that exchange money has reached your pocket. That is boot, taxable in the year of the exchange.

What are the clean ways to handle it?

Have the intermediary pay the deposit. Where timing allows, the deposit comes directly from exchange funds. Nothing is reimbursed and the deposit is simply part of the purchase.

Pay it yourself and apply it to the purchase price. The deposit is credited against the price at closing, so you contribute that money to the purchase rather than receiving it back. Your own money has gone into the property, which increases what you have invested but does not create boot.

Pay it yourself and take it back deliberately. If you want your deposit money returned, understand that it may be treated as boot depending on how the closing is structured, and plan for the tax.

The first two are the usual answers. The third is a choice, not an accident.

Why does it get mishandled?

Because closing agents prepare statements to reflect who paid what, and returning a buyer's deposit looks like a neutral administrative step. Nobody involved is thinking about constructive receipt.

It is also small enough to escape attention. A 50,000 dollar deposit on a 2 million dollar purchase is easy to overlook, and 50,000 dollars of boot on a long held rental can still cost 12,000 to 15,000 dollars in tax.

What about deposits on the property you are selling?

Deposits from your buyer are part of the sale proceeds and should flow to the intermediary along with the rest at closing. They should not be released to you separately.

What about deposits that are forfeited?

If a buyer forfeits a deposit to you, that is generally taxable income rather than part of an exchange. If you forfeit a deposit on a replacement property that falls through, the treatment depends on the circumstances and should be discussed with your CPA.

What else on the settlement statement deserves the same attention?

The deposit is one of a family of items that can quietly move exchange money into your hands:

• ›Prorated rent credited to you
• ›Security deposits transferred at closing
• ›Repair credits
• ›Reimbursement of inspection or appraisal fees you paid personally
• ›Funding of tax and insurance impound accounts from exchange proceeds

Each is small individually. Together they can add up to a meaningful amount of boot.

Who should review it?

Your Qualified Intermediary and your CPA, on the draft statement, before closing. Intermediaries see these patterns constantly and can usually fix the presentation in a single email to the closing agent.

What does a worked example look like?

You pay a 60,000 dollar deposit personally on a 2.4 million dollar replacement property. At closing, the intermediary wires 1.9 million dollars of exchange funds and you arrange a 500,000 dollar loan.

If the statement applies your 60,000 dollar deposit as a credit toward the price, the purchase is funded by exchange money, your loan and your own 60,000 dollars. Nothing comes back to you and there is no boot. You have simply put additional personal money into the property, which increases your basis.

If instead the statement shows the intermediary funding the full price and returning 60,000 dollars to you, exchange proceeds have reached your pocket. That is 60,000 dollars of boot, taxed against depreciation recapture first on a long held property.

The economics are almost identical. The tax result is not, and the difference is a single line on a document prepared by someone who does not know your tax position.

Can the intermediary pay the deposit directly?

Often yes, once the exchange account is funded, which usually means after your sale has closed. If the replacement property goes under contract before your sale completes, the intermediary has no funds to use, which is why personal payment is so common.

Ask early. Some intermediaries can wire a deposit within a day of receiving instructions, which removes the question entirely.

What to do first

When you make an offer on replacement property, ask your intermediary how the deposit should be paid and how it should appear on the closing statement. If you have already paid a deposit personally, tell them, and confirm that it will be applied to the purchase price rather than refunded to you.

Then ask for the draft settlement statement a week before closing and have both advisers read it.

Nothing here is tax, legal or investment advice. Treatment depends on the structure and documentation of your transaction. Confirm with your CPA and Qualified Intermediary before closing.