Pro-Rated Rents & Deposits
From Kevin Hummel
McFerran Law, PS.
The Business vs. the Real Estate
My weekly updates regarding §1031 exchanges write themselves. Any week that I find I am addressing the same subject more than once, it becomes the next update topic. This week it was addressing handling the pro-rations of rents and deposits in escrow.
When you hear anything about a 1031 they always mention that it is a “Like-Kind Exchange”. That terminology causes much confusion, but essentially means that the sale and purchase has to be Investment Real Estate. In layman’s terms, that means that you are creating income on it (like a rental), operating a business on it (like commercial), or holding for appreciation (like raw land). It also means that you are not selling or purchasing the business that operates on that property. A Business Opportunity is not exchangeable.
The Business of Renting
When you stop and think about it, the process of renting of investment property is the business operating on the property. That is why we specifically instruct escrow closers to make certain that they are not including the pro-rations of rents and deposits on the Settlement Statement when closing a 1031 exchange. In our QI Escrow Instructions we always include this statement:
Matters Outside of the Exchange
For the property being conveyed in this transaction, matters regarding adjustments between the Exchangor and Buyer regarding prepaid rents, security deposits and other adjustments or pro-rations normally made at closing regarding matters of tenant income be made between the parties outside of escrow and not a part of the formal Settlement Statement.
If the Exchangor and Buyer authorize you to make these calculations, they must be accounted for separately and proceeds distributed at closing by separate check clearly identifying the nature of the proceeds. Such check cannot be drawn from Exchangor’s proceeds which will be distributed to us as the QI.
We suggest that you collect any prepaid rent and security deposits from the Exchangor directly with funds outside the closing and transfer that amount to the Buyer after recording by separate check. If the type of property being exchanged is not rental property, these instructions do not apply.
We do this to make certain that those funds being released out of the sale proceeds aren’t misconstrued as “boot” or taxable. Of course if you are only selling a single family residence, it might be a minimal tax. It is when you are selling an apartment building that it could be quite a substantial unintentional tax.
At that point, an Exchangor could decide that they are willing to pay tax on that as boot, and that is their prerogative to do so. We just do all that we can to avoid any surprises and always working to avoid any taxation, if we can.
Extra Precautions
We also recommend that these issues are address in the original Purchase and Sale Agreement to avoid any surprises for everyone involved. We are happy to provide you with an Addendum that can help address this issue. It can be used for any purchase or sale that might become part of an exchange. Let me know if you have an interest in that.
Never Too Early to Talk
In many cases, it just starts with a phone or email to me. We will call your client to make certain they understand and agree to the terms. I sincerely look forward to a call or email from you or your client.
Kevin Hummel
Regional Account Manager
McFerran Law, P.S.
3906 S. 74th St., Tacoma, WA 98409
Phone: (253) 882-9199
[email protected]
Offices in Tacoma, Kent, Seattle (Northgate), Everett and Silverdale.
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