As the seller doing a 1031 exchange, can I hold the earnest money?
A: Yes, you can deposit the earnest money into your personal account. Earnest money is not considered “proceeds” until after the closing takes place. Therefore, it is very important to bring a check for that earnest money in a format acceptable to the closing attorney/title company at or before the closing. Because the earnest money is part of the down payment the purchaser is making, it will then be re-characterized from earnest money to proceeds and forwarded to the qualified intermediary.
If you are still in possession of the earnest money after the closing, then you will have to pay tax on that amount. Additionally, there are some experts in the 1031 industry who believe the quality of your exchange could be impacted and potentially open for attack by the IRS if the earnest money is not refunded to the closing.