Are tenant security deposits and rent prorations boot in a 1031 exchange?

The regulation names prorated rent, which settles half the question in one sentence

Treas. Reg. §1.1031(k)-1(g)(7)(i) disregards 'items that a seller may receive as a consequence of the disposition of property and that are not included in the amount realized from the disposition of property (e.g., prorated rents)'. Taking your share of the closing month's rent at the table does not break the safe harbor and does not touch the exchange.

It is not boot for a simpler reason as well. Rent for the days you owned the building is ordinary rental income reported on Schedule E, so it was never part of the price you received for the property and can never be part of the money treated as received in the exchange.

Handle it as income, not as proceeds: a $9,000 rent proration on a September closing is September rent, and it belongs on the same line as the eight months before it.

A deposit credit is the tenants' money, and that is exactly what makes it dangerous

Publication 527 tells landlords: 'Don't include a security deposit in your income when you receive it if you plan to return it to your tenant at the end of the lease.' It sat on your books as an obligation, never as revenue, and at closing the buyer takes over the obligation and takes a credit for the cash.

Intermediaries, citing TAM 8328011, treat that obligation as something other than a liability of the property for exchange purposes. The consequence is the practical one: because it is not debt relief, you cannot offset it by borrowing more on the replacement. The only cure is cash.

So the credit leaves a hole exactly its own size. The contract price is what you must reinvest; the wire to your intermediary is smaller by the credit; and the difference is recognized gain unless you put your own money in.

Worked example: a hypothetical $3,000,000 apartment sale with $40,000 of deposits

Assume a $3,000,000 price, $180,000 of commissions and title charges, $40,000 of security deposits, $12,000 of last month's rent collected at lease signing, and $9,000 of prorated September rent you receive. Basis is $900,000 and there is no mortgage.

Exchange expenses of $180,000 come off the money treated as received. The $9,000 of rent is income and stays outside. The $52,000 of deposits and advance rent is credited to the buyer, so the intermediary receives $2,768,000 while the price you must match is $2,820,000 after expenses.

Buy a replacement for $2,768,000 and $52,000 is boot. Bring $52,000 of your own cash to the replacement closing, buy at $2,820,000, and nothing is recognized. You already hold that $52,000; it is the tenants' money sitting in your operating account.

• Price $3,000,000 less $180,000 of exchange expenses: reinvestment target $2,820,000.
• Credits to the buyer: $40,000 of deposits plus $12,000 of advance rent.
• Wire to the intermediary: $2,768,000. Shortfall: $52,000.
• Adding a $52,000 larger loan on the replacement does not fix it, because no debt was relieved.
• Round hypothetical numbers used to show the arithmetic, not to model a real building.

The cleaner move: take the deposits off the settlement statement entirely

Ask the buyer's counsel to handle the deposits as a separate transfer outside escrow, documented by a deposit-transfer schedule and a wire from your operating account on the closing date. The settlement statement then shows the full $3,000,000 going to the intermediary and nothing needs to be made up later.

Do the same with last month's rent. Publication 527 is blunt that advance rent goes 'in your rental income in the year you receive it regardless of the period covered or the method of accounting you use', so handing it to the buyer is settling an obligation on money you were already taxed on, not selling anything.

Raise this with the buyer before the contract is signed. Once a purchase agreement says deposits will be credited at closing, changing the mechanics needs the buyer's cooperation, and your exchange cooperation clause is the natural place to have asked.

CAM reconciliations, tenant improvement allowances and repair credits follow the same test

Ask one question of every credit: is it a reduction in what the buyer is paying for the real estate, or is it you settling an obligation you already owed? A negotiated price reduction for a roof lowers both the price and your amount realized, so nothing is left over. An obligation you carry forward, funded by a credit, behaves like a deposit.

Over-collected common area maintenance estimates owed back to commercial tenants, unfunded tenant improvement allowances under signed leases, free-rent periods you agreed to and outstanding leasing commissions all belong in the second group. Fund them yourself or accept the shortfall.

Property tax prorations behave differently again, because Reg. §1.1001-1(b) keeps the buyer's share out of your amount realized; the full sweep of the settlement statement is in which closing costs can be paid from exchange funds.

• Reduces the price and the amount realized: repair credits, price adjustments after inspection.
• Settles your own obligation and leaves a hole: security deposits, pet and key deposits, advance rent, CAM refunds owed, unfunded TI allowances, unpaid leasing commissions.
• Neither: real property tax and assessment prorations, which sit outside amount realized on both sides.

The four numbers to pin down before the relinquished closing

Run these before the statement is drafted, and have your own CPA or attorney confirm the treatment of anything unusual in your leases, because the characterisation lands on your return.

Breakwater Exchange is a 1031 exchange broker with more than twenty years of experience, and multifamily and net-lease Delaware Statutory Trusts from vetted national sponsors are one way to absorb the extra cash a deposit credit forces you to bring (multifamily as replacement).

• Total security deposits held, tenant by tenant, reconciled to your trust or operating account.
• Advance and last month's rent collected, with the months it covers.
• CAM, tax and insurance estimates collected against the actual figures for the year to date.
• Any lease obligation the buyer will inherit unfunded: allowances, free rent, commissions.