Business Management

1031 Exchange: What Investors Should Know About Closing Costs

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When planning for a 1031 exchange, it's important to have a target reinvestment amount. Why? Because to defer all tax in a 1031, you must purchase at least as much replacement investment real estate as your net sale.

But… what is the net sale? Well, the easy answer is the contract price minus closing costs and commissions. So which closing costs count in this equation?

Frankly, as in many aspects of the 1031 exchange, there isn't a crystal clear answer to that question.

Here’s how the tax code on this subject reads.

“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), and (ii) Transactional items that relate to the disposition of the relinquished property or to the acquisition of the replacement property and appear under local standards in the typical closing statements as the responsibility of a buyer or seller.”

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See what I mean? Because the language of the code is open to interpretation, there is room for error. Consequently, you can read “error” as “taxable gains.”

Related: The Ultimate Guide to Real Estate Taxes & Deductions

calculator with less tax and more tax buttons

1031 Exchange Eligible Expenses

Fortunately, the IRS provides examples of qualified 1031 exchange expenses. Referred to as exchange costs, the IRS allows payment with exchange funds. That’s because these costs are considered typical closing costs related to the sale of property. As a result, using exchange funds to cover these costs won’t result in tax penalties or the disqualification of your exchange.

Exchange costs include:

  • Escrow fees
  • Broker’s commissions
  • Mandatory appraisal costs (purchase contract only)
  • Attorney costs related to the sale
  • Recording fees
  • Title insurance costs
  • Transfer taxes
  • Prorated taxes
  • Qualified intermediary fees

Expenses Not Covered by 1031 Exchange Funds

While there are some expenses that you can clearly use exchange funds to cover, there are others that are not eligible.

Exchange funds do not cover: 

  • Costs of financing
  • Prorated rent
  • Security deposits

Related: How a 1031 Exchange Can Make You Millions

closeup of hand using scissors to cut paper that reads taxes

If you use exchange funds to cover these types of costs, then the IRS treats them as cash taken out of the exchange. This is known as “boot.”

As a result, this boot portion of your proceeds becomes taxable. Consulting with an experienced qualified intermediary (QI) will reduce the likelihood of simple mistakes like this being made.

Also, you should avoid using exchange funds to cover:

  • Property taxes
  • Appraisals required by a lender
  • Insurance premiums

These are typically expensed costs and therefore not included on a closing statement.

In addition, take care not to use exchange funds to pay for anything between the sale of your property and purchase of your reinvestment property. This avoids a “constructive receipt” of funds issue.

Instead, pay these out of pocket. This includes lender lock-in fees. Exchange funds and loans do not mix!

The Bottom Line

With this in mind, take advantage of every allowable 1031 exchange cost at closing. Involve your tax professional and qualified intermediary in determining which costs may be paid with your exchange proceeds. They will be able to tailor their guidance to your particular situation.

References

Legal Information Institute. “26 CFR § 1.1031(k)-1 – Treatment of deferred exchanges.” https://www.law.cornell.edu/cfr/text/26/1.1031(k)-1. Accessed 01 July 2019.

Government Publishing Office. “CFR-2011-title26-vol11-part1-subjectgroup-id46.pdf.” https://www.govinfo.gov/content/pkg/CFR-2011-title26-vol11/pdf/CFR-2011-title26-vol11-part1-subjectgroup-id46.pdf. Accessed 01 July 2019.

Do you have any other questions about 1031 exchanges? 

Ask me in the comment section below!

 

Dave Foster, real estate investor and qualified intermediary, has 20 years of experience working in all phases of real estate investing, from large scale development to single family homes and vaca...
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    Deanne Bourne Investor from Concord, California
    Replied about 1 year ago
    Your intermediary should be able to get the 1031 done correctly. Plus don’t you just pay taxes on the amount that isn’t committed to the new property. Say you make a $2000 mistake and the new property costs are cheaper than the one being sold; don’t you just see that $2000 as a taxable gain (boot) or do you lose the whole effort of the exchange?
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied about 1 year ago
    Great comment Deanne, And you’re absolutely right. You would only pay the tax on the difference between your net sale price and the net purchase price if the net purchase price was smaller. Because of this many of our clients choose to let their exchange pay for all closing costs on the settlement statement. And their accountant then makes any adjustments for disallowed closing costs when they report the exchange on the clients tax return. D
    Sergio Francis Investor from Washington, District of Columbia
    Replied about 1 year ago
    Thanks for the information. I am strongly considering doing a 1031 soon
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied about 1 year ago
    So glad it was helpful Sergio. Hopefully we can work together. D
    Katia May Rental Property Investor from Philadelphia, PA
    Replied 11 months ago
    Hi David, I am going to sell a rental condo in PA and want to buy a house to rent in FL (Delray Beach). Can you recommend a good intermediary in PA (preferably Philadelphia area)? Also when I buy the house in FL how long time I will have to rent it? What if it takes couple months to find somebody to rent the house? Thanks. Katia
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 11 months ago
    Hi Katia, Thanks for reaching out. The qualified intermediary for 1031 exchanges is rarely local to the transaction. Since the QI must be an unrelated party to the client it is difficult to develop a scale of business if that's all you do because of the limited pool of 1031s in any specific location. So most QIs operate nationally. Additionally it is just as common for a 1031 to start in one state and end in another. So your QI is going to have to have an understanding of two states anyway. It's better to search for a QI by depth of experience and personal vetting. Being a competent QI involves an in depth knowledge of an incredibly complicated statute. Not may want to specialize in it. So the best ones are almost always going to be those with a national reach.
    Remone Randolph from Auburn, Washington
    Replied 8 months ago
    question..im in a 1031 exchange and the replacement property will be about 7k less than the relinquished property so i understand i would pay cap gains on the 7k which is the difference. But if we have the seller pay our closing costs would that amount also be taxable?
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 8 months ago
    Hi Remone, If you have the seller pay closing costs that would have the same effect as you purchasing for a lesser amount. So that would increase that $7000 discrepancy. But remember that the tax is only a small % of the gain. So if you get them to pay $5000 of closing costs it could be just a $1000 cost to you = a $4000 net benefit to you. That might take some sting out the tax bite :)
    Stephanie Gibson
    Replied 6 months ago
    Hi Dave, I'd like to gain an understanding of what the tax implications could be if I walk away from closing with left over exchange funds. I know that amount would be taxed. Is it true that I could deduct certain expenses for the relinquished property, such as renovation costs, that would lower the tax payment? Are there other types of expenses from a relinquished property that can be written off as well? Also, it seems like it's very difficult to find accountants that deal with 1031. I would like to discuss my situation with an accountant with 1031 knowledge prior to my closing. My accountant isn't versed in it and doesn't know anyone who is. I've reached out to one and haven't heard back from them yet. Any advice? Thanks Stephanie
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 6 months ago
    Thanks for reaching out Stephanie, It is a very confusing area - primarily because every kind of expense that could be put on a settlement statement can't be imagined. So the specifics are vague and in some cases left up to interpretation. In addition to what I shared in the article I'd be happy to start a dialogue with you and see if we can provide some guidance for you. Let's reach out via PM. Dave
    Paul True from Merlin, Oregon
    Replied 6 months ago
    Hi Dave, Little confusion you might want to clear up. Under Allowed Expenses you list "Prorated Taxes" then further down you say to avoid Property Tax payments. I have an exchange where property taxes were paid from the sale proceeds and the transfer to the intermediary was reduced by that amount. It was a cash transaction and I have no idea how to show that payment (which I assume is treated as income) on the 8824. Any thoughts?