If you are using a 1031 exchange to defer capital gains taxes when selling an investment property, it’s natural to focus on the real estate itself—what you sell, what you buy, and whether the deal closes on time. But two equally important questions are:
1. .What happens to the cash in between?
2. .What are the tax consequences for funds received from the QI?
In a standard 1031 exchange, a Qualified Intermediary (QI) holds your sale proceeds while you identify and purchase your replacement property. During this time, your money may earn interest, and, in some cases, a portion of your funds may be returned to you if they are not reinvested. Both of these events can have tax consequences.
This blog explains how:
Uninvested funds that are returned to you by the QI are treated for tax purposes, and
Any interest earned while the QI holds your funds is taxed.
Quick Refresher: How a 1031 Exchange Works
Under Section 1031 of the Internal Revenue Code, you can defer capital gains taxes when you sell an investment or business property—so long as you reinvest the proceeds into one or more “like-kind” replacement properties within specific timelines and follow strict IRS rules.
In most exchanges, a Qualified Intermediary (QI) is required. The QI’s job is to:
• Receive your sale proceeds directly from escrow at the closing of your relinquished property.
• Hold those funds during the exchange period.
• Disburse them to acquire your replacement property (or properties).
Two key deadlines drive the process:
• 45 days from the sale date to identify potential replacement property.
• 180 days from the sale date (or your tax filing deadline, if earlier) to close on the replacement property.
As long as all the proceeds are reinvested, and all other requirements are met, you may fully defer capital gains and depreciation recapture. However, if any cash comes back to you, or if the funds earn interest while sitting with the QI, those amounts may be taxable.
How Uninvested Funds Returned by the QI Are Treated
When you sell your relinquished property, you may not end up using every dollar of your exchange proceeds to acquire replacement property. There are three common situations where funds are returned to you by the QI:
1) You deliberately reinvest less than 100% of your proceeds.
• Example: You sell a property and net $1,000,000 of exchange proceeds, but only use $850,000 to purchase replacement property.
• The unused $150,000 is typically returned to you by the QI at or after the completion of the exchange.
2) Your exchange only partially succeeds.
• Example: You identify multiple properties but only manage to close on one within the 180-day window.
• The QI will return any remaining unused funds after the exchange period ends.
3) The exchange fails entirely.
• Example: You are unable to identify or close on any replacement property within IRS deadlines.
• Once the exchange period ends, the QI must return all proceeds to you.
In all of these scenarios, **any cash that comes back to you from the QI is generally treated as taxable “boot.”** Boot is the term used for cash or non-like-kind property you receive in a 1031 exchange. Boot is usually taxable in the year of the sale, up to the amount of gain realized.
Key points for investors:
• Returned cash is not magically tax-free just because you attempted a 1031 exchange.
• The taxable portion may consist of state and federal capital gains, depreciation recapture, and a net investment tax (Obamacare) depending on your cost basis and prior depreciation.
• You will typically recognize gain to the extent of the lesser of (a) the boot you receive, or (b) your total realized gain on the sale.
Because of these rules, it is important to work with your advisor team in advance to estimate how much of your proceeds can and should be reinvested if you want to maximize tax deferral.
Is Interest on Funds Held by a QI Taxable?
While your proceeds are parked with the Qualified Intermediary, they may be placed in an interest-bearing account such as a money market fund or bank deposit. Even though you cannot access these funds during the exchange period, the IRS generally treats any interest earned as taxable income to you.
In practice, this usually works as follows:
• The QI tracks any interest earned on your exchange account.
• At year-end, the QI (or the financial institution where funds were held) will issue you a Form 1099-INT.
• You report this interest as ordinary income on your tax return for that year.
Important distinctions:
• The **principal exchange proceeds** remain eligible for 1031 deferral if all other requirements are met.
• The **interest** is not part of the like-kind exchange; it is simply investment income and is taxable in the year it is earned.
• Earning interest on exchange funds does **not** by itself disqualify the 1031 exchange, as long as you never have constructive receipt of the principal before the exchange is completed.
Some QIs offer interest-free accounts (often in exchange for lower fees or simpler structures). In those cases, no taxable interest income is generated, but you also earn no return on your idle cash.
Planning Tips to Reduce Tax Surprises
Here are some practical steps to help manage the tax impact of uninvested funds and QI-held interest:
1) Model your exchange before you sell.
• Work with your CPA or financial advisor to estimate your gain, potential boot, and the reinvestment targets needed to achieve your desired level of deferral.
2) Be realistic about your replacement property strategy.
• If you know you will not reinvest 100% of your proceeds, plan ahead for the taxable boot and consider strategies to offset it (such as other capital losses or charitable planning).
3) Ask your QI how exchange funds will be held.
• Will the funds earn interest? At what approximate rate?
• Who will issue the Form 1099-INT, and when?
4) Coordinate your timing with your tax year.
• Because interest is taxable in the year it is earned, and boot is typically recognized in the year of sale, timing can matter—especially if you are near a tax bracket threshold.
5) Keep clear records.
• Maintain copies of your exchange agreement, QI statements, closing statements, and any Forms 1099-INT.
• Your tax advisor will use these documents to properly allocate gain, basis, boot, and interest income.
With thoughtful planning, you can use the 1031 exchange rules to defer significant taxes while understanding and managing the smaller pieces—like returned cash and interest—that remain taxable along the way.
Final Thoughts
Tax treatment of 1031 exchanges, boot, and interest income can vary based on your specific facts, other holdings, and changing tax laws. Always consult with your own qualified tax advisor, attorney, and financial professional before making any decisions related to a 1031 exchange or other tax-sensitive transactions.
We welcome your questions. Contact us today to discuss by emailing us at info@firstguardiangroup.com or schedule a no-obligation consultation today!
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