Who holds the earnest money deposit in a 1031 exchange, and can the QI pay it?

Escrow should hold the replacement deposit, because a seller-held deposit is out of reach

Your offer should direct the deposit to the title company or escrow agent, held under the purchase contract and credited to the price at closing. That keeps it inside the closing, where the intermediary's funds and your credits are reconciled on one statement. Deposit size is a contract term rather than a tax rule, but a large deposit paid before the intermediary is assigned in ties up your own cash until closing.

A deposit paid to the seller directly, or released to the seller before closing, leaves the exchange's paper trail: if it came from exchange funds it is money that left the qualified escrow without buying property, and if it came from you it can be recovered only as a credit the closing agent can see. Do I need an exchange cooperation clause? lists the purchase-side terms that keep the deposit in escrow.

The QI can wire the deposit from exchange funds, but only after it is assigned into the contract

Asset Preservation states that the intermediary can advance funds for the deposit once the contract has been assigned through the exchange documents making the intermediary the purchaser of the replacement property. Legal 1031 says the same thing from the other direction: to use exchange funds for a contract deposit, it must first be assigned into the purchase transaction.

Legal 1031 describes the sequence as seven steps: you send it the unsigned contract; it prepares the replacement-property exchange documents; you sign the contract and the exchange documents; the package goes to the seller; the seller signs the contract and the notice of assignment; the intermediary wires the deposit; the originals come back. Build a few business days into your offer's deposit deadline for that loop, and ask for the intermediary's replacement-property document package the day your offer is accepted.

The regulation permits this because the intermediary is spending exchange money to acquire replacement property on your behalf, which is its job under the exchange agreement (26 CFR 1.1031(k)-1(g)(4)(iii)). What it cannot do is hand money to you.

A deposit you paid yourself comes back only through the closing statement

Asset Preservation is explicit that an intermediary cannot make a direct reimbursement of a deposit to the taxpayer, but can replace a taxpayer's deposit held by a closing agent with exchange proceeds for reimbursement at closing. Legal 1031 says reimbursement should be handled through the closing settlement process.

The reason is the safe-harbor restriction: the exchange agreement must give you no right to receive, pledge, borrow or otherwise obtain the benefits of the money before the end of the exchange period (26 CFR 1.1031(k)-1(g)(6)). A check from the intermediary to you mid-exchange breaks that restriction.

Hypothetical example with round numbers: you paid a $20,000 deposit from savings on a $500,000 replacement, and the intermediary holds $500,000. At closing the intermediary wires the full $500,000, the statement credits your $20,000 deposit against the price, and the closing agent refunds the $20,000 to you as an overpayment; your CPA or attorney should check that statement before it is final.

Reverse the wires and the result changes: if the intermediary sends only $480,000 and your deposit stays in the deal, the $20,000 left with the intermediary is returned after closing and taxed as boot. Legal 1031 warns that funds received from an intermediary after the exchange has closed are boot, not reimbursement; What is boot in a 1031 exchange? explains how it is taxed.

Earnest money on your sale must reach the intermediary or closing agent before you close

The mirror problem is the buyer's deposit on the property you are selling. Asset Preservation explains that if you enter the exchange agreement before closing and then deposit the earnest money with the intermediary or the closing agent before the closing occurs, the deposit is not treated as receipt of sale proceeds, but a deposit you keep through the closing is boot, taxable to the extent of your gain.

The clean structure is a deposit held by escrow from day one and disbursed with the rest of the proceeds to the intermediary. If a buyer offers a deposit paid to you or released early, read Can I accept an option payment or early release of earnest money? before agreeing.

Forfeited deposits and deposits that never get reimbursed

If exchange funds pay a deposit and you then default, the money went to a seller without acquiring replacement property. Neither Asset Preservation nor Legal 1031 publishes a rule for that outcome, and the regulation's list of disregarded transactional items covers commissions, prorated taxes, transfer taxes and title fees rather than forfeited deposits (26 CFR 1.1031(k)-1(g)(7)), so treat a hard deposit funded by the intermediary as money at risk of being taxed as received and ask your CPA before you let one go non-refundable.

A personal deposit you never take back at closing is simply extra cash you put into the replacement. It is not boot; it raises your basis in the new property, and Can I add my own cash to the exchange? and How do I calculate basis in the replacement property? show where it lands.