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

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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 vacation rentals. This experience has given him a keen eye for opportunity and a clear vision for reducing the impact of taxes. A degreed accountant with a Master’s in management, Dave is Regional Director for Exchange Resource Group and has recently launched his own educational website, The 1031 Investor. Dave has built his reputation on being a driven, results-oriented 1031 Exchange Qualified Intermediary who works relentlessly to maximize value for the real estate investors he works with. He has taught numerous certified continuing educations courses on investment tax strategies. His particular focus on basic and advanced 1031 exchange topics has made him a popular guest speaker for local realtor associations, investment clubs, and podcasts. He teaches agents, investors, and advisors alike the ins and outs of 1031 exchanges and other tax and investment options.

    Deanne Bourne Investor from Concord, California
    Replied 4 months 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 3 months 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 4 months 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 3 months ago
    So glad it was helpful Sergio. Hopefully we can work together. D