When it comes to 1031 exchanges, the key to full tax-deferral of capital gains is avoiding any real or constructive receipt of sale proceeds or other income related to the overall transactions. It sounds easy enough in theory, but many investors unwittingly violate this rule – and end up with taxable funds – when it comes to prepaid rent and security deposits on relinquished rental properties.
In a typical, non-1031 exchange closing, any prepaid rents or security deposits held by the seller are credited to the buyer at closing. It is a clean way to do the transfer of these assets related to the sold real estate. However, the rules change when it comes to the same property involved in a 1031 exchange. In an exchange, rent and security deposits are classified by the IRS as income items and can’t be offset against any recognized gain.
If the seller of the relinquished property, who intends to complete an exchange and obtain replacement property, offers a credit to the buyer for prepaid rents and security deposits, that credit amount cannot be offset against the investor’s gain in the sale, leaving the investor exposed for the amount of the credit. The IRS will impute this credit as a taxable gain.
There is, of course, an easier way to avoid this situation. To avoid this type of unexpected boot, the investor seller should avoid providing credits to the buyer for rent and security deposits. Instead, the seller should directly transfer such income items to the buyer as a separate, but related, part of the overall transaction. This leaves the investor safe from unintended taxes on unexpected boot.