The short answer
The intermediary can send the money, but you will generally pay tax on it. Lender escrow reserves for future taxes and insurance, prepaid insurance premiums and per-diem interest on the new loan are costs of the financing or deposits you still own, not costs of acquiring the property, so they fall outside the transactional items that Reg. section 1.1031(k)-1(g)(7) lets exchange funds pay. Exchange money spent on them is treated as boot. Bring a separate check for those lines and let the exchange funds cover only price and true closing costs.
At a glance
| Lender impound deposits | Your money held for future bills; generally boot if paid from the exchange |
|---|---|
| Prepaid insurance premium | A cost of insuring, not of buying; generally boot |
| Per-diem interest | A loan cost; generally boot |
| Prorated property taxes | Listed in the regulation as a transactional item; fine |
| Title, recording, transfer tax | Listed transactional items; fine |
| Fix | Pay the financing lines with outside cash at the replacement closing |
| Hypothetical | $13,500 of reserves from exchange funds: about $3,900 federal tax |
The regulation protects transaction costs, and lender reserves are not transaction costs
Reg. section 1.1031(k)-1(g)(7)(ii) disregards 'transactional items that relate to the disposition of the relinquished property or to the acquisition of the replacement property and appear under local standards in the typical closing statements as the responsibility of a buyer or seller.' Its examples are commissions, prorated taxes, recording or transfer taxes and title company fees.
An impound deposit is not a cost of acquiring the building. It is a balance your lender holds on your behalf to pay next year's taxes and insurance, and it remains your money: if you pay off the loan, the balance comes back to you. Spending exchange funds to create it is receiving something other than like-kind real estate.
Prepaid hazard insurance and per-diem interest fail for related reasons. One buys an insurance policy, the other pays for the use of the lender's money before the first payment date. Neither is the price of the property or a cost of transferring it.
Prorated taxes and impound deposits look alike on the statement but are treated differently
Settlement statements often put the seller's tax proration and the lender's tax reserve a few lines apart. The proration reimburses the seller for taxes already paid on days you will own the property, and the regulation names prorated taxes as a protected item, so exchange funds may cover it.
The reserve is a deposit toward future tax bills you have not yet incurred. It belongs with the loan, not with the purchase. Read the statement line by line; the companion page on the settlement statement for a 1031 exchange explains which section each charge sits in.
The same split applies on the sale side, where rent prorations and tenant deposits are handled differently from each other; see security deposits and rent prorations as boot.
Worked example: $13,500 of lender charges on a $1 million purchase
Hypothetical, round numbers, state tax ignored; run your own numbers with your CPA. You buy a $1,000,000 replacement with a $600,000 loan and $400,000 of exchange funds. The lender also requires $6,000 of property-tax reserves, a $4,000 first-year insurance premium, a $2,000 escrow cushion and $1,500 of per-diem interest: $13,500.
If the intermediary wires $413,500 and escrow applies the extra $13,500 to those lines, you have $13,500 of boot. Taxed from the depreciation layer at up to 25% under Topic 409, that is $3,375, plus $513 of net investment income tax above the threshold: about $3,900.
If you wire $13,500 of your own money for those lines instead, the full exchange amount goes to price and true closing costs and no gain is recognized. The reserves and prepaid items are then simply your own money, recovered or deducted under the normal rules.
What to do before the replacement closing
Ask escrow for a draft settlement statement several days before closing and mark every line as purchase price, transactional item or financing item. Send the intermediary a written instruction that exchange funds may pay only the first two groups.
Arrange a separate wire from your own account for the financing group. If the reserves are large, ask the lender whether it will waive impounds. Either way, the lender's appetite does not change the tax result.
The broader list of what exchange funds can and cannot pay is in can closing costs be paid from exchange funds, and lender origination charges are covered in loan fees and points paid from exchange funds. Whether the allowed costs are deducted or added to basis is in are exchange fees deductible or added to basis.
A trust interest has no lender reserves at your level
When you buy a Delaware Statutory Trust interest, the financing sits with the trust, which carries any reserves the loan requires inside the offering. Your subscription is for the interest itself, so there is no personal impound account to fund at closing.
That is one reason some exchangers use a trust interest for the last dollars of a split exchange. The trade-offs, including loss of control, are on our traditional DST page, and how a trust's loan is treated as your replacement debt is in does a DST's loan count as replacement debt.
Related questions
If my lender refunds the escrow balance later, is that taxed again?
No. A refund of your own deposit is not income. The tax issue arises only at the closing, when exchange money was used to fund the deposit.
Is a lender-required repair or replacement reserve different?
A capital reserve the lender holds for future work is also a deposit, not part of the price, so it raises the same boot issue when funded from the exchange.
Can I just borrow more to cover the reserves?
Borrowing more changes where your own cash comes from, not the character of the line. The reserve still has to be paid by someone, and it should not be paid by the intermediary.
Does the intermediary decide what is allowed?
No. The intermediary follows your instructions; the tax result follows the regulation. The decision and the tax are yours.
Where does this boot show up on my return?
It is part of the cash received on line 15 of Form 8824, as described in the Form 8824 instructions.
Sources
Checked against these publications on September 30, 2026. Rules and figures change; confirm the current version with your CPA or attorney before you act. This page is general information, not tax or legal advice.