Hello All.

I am buying 2 unit investment property. I am reviewing my HUD statement and last 9 months taxes, security deposit for both sides, and prorated rent is in 200 section and is being applied to the loan which I am taking.

My questions. I was told because I am using 1031 exchange money for this property that I can not receive any money back after closing or if I did it would go back to the 1031 company then it would be disbursed back to me and I will have to pay taxes on it.

Because of this they are applying the security deposit to the principal because I can not receive any money back and it is in the purchase contract that I receive the deposit. My title company said because it is in the contract she has to put it on the HUD it is the only way to guarantee to get the money. We could do a side addendum and remove it from the HUD but i feel there has to be another way. That it could stay in purchase contract not go on the HUD and receive the deposit check at closing from the seller. I talked to my accountant and he said per Ohio law that technically we are not allowed to have it on the HUD and be payed towards the loan amount I am taken because it is the not the sellers money or mine it is the tenants until they move out.

Is my title company wrong in saying that the purchase contract has to be changed and security deposit removed from the contract or if not she is obligated to put it on the HUD as it is the only way to guarantee the money?

Also unrelated after the down payment I will have about 22k left over from my 1031 that I will either receive back and pay 15% taxes on. I owned the previous house for more than 1 year so that's why capital gains tax is that much in Ohio according to my accountant.  or should I pay apply it to the principal mortgage and have further equity I can borrow against. The house appraised for 315k and I bought it for 270k so already have 45k in equity. 

I will pay$3300 in taxes but will have freedom to either renovate other properties, use as down payment or whatever. On other hand if I use it to pay down principal I will have further equity but I figured if I cash out refinance to use on another house I will pay at least couple thousand in closing costs, title, origination fee, etc. So I guess is it worth to save 1k or spend pay that to have more freedom.  Thanks all!

This isn't correct. You need to look at it more like purchasing a business than buying a house. My suggestion would be to have the title company or an attorney place those funds in an escrow account or other security that is separate from the transaction. I'm not claiming to be a tax or legal expert, but this is what I have seen done before. Maybe  

@Timothy Murphy III could provide more insight. 

@Matt Motil

I was actually just responding to @Eric S. 's other post on the subject when you pinged me.

I don't know this for a fact, but I'd presume that the security deposit funds could remain deposited with the qualified intermediary that's facilitating the 1031. The treasury regs provide for using the qualified intermediary as a safe harbor. The big key is that you never touch or otherwise get direct control of the cash. Check with your QI as I'd have to imagine they handle this specific question quite frequently.

@Eric S.

As an intermediary we usually request that prepaid and prorated  rents, and security deposits be handled outside of closing.  Your right it should have nothing to do with the 1031 but it it goes on the hud it is messy and easier for the service to claim you are receiving boot  A simple statement to that effect can go into the contract and the title company may even be willing to handle that part for you.

Re: the excess funds- depending on valuations and any work needed on your replacement properties there may be a way to enfold that into improvements to tour replacements and still keep tax deferred status of that money

Thanks everyone really appreciate it! Makes since now. Thanks!