Log In Sign Up
1031 Exchange: What Investors Should Know About Closing Costs

1031 Exchange: What Investors Should Know About Closing Costs

2 min read
Dave Foster

Dave Foster is a real estate investor and qualified intermediary, who believes that real estate is an investment in the future.

Experience
Dave’s 20 years of experience working in all phases of real estate investing—from large scale development to single family homes and vacation rentals—have 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 at The1031Investor.com. 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.

Dave is inspired by a genuine desire to help those around him succeed and continuously strives to create win-win situations. He has taught numerous certified continuing education 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.

Dave started his investing career with a fix and flip duplex, then pivoted to single family housing with a buy and hold strategy. After building a rental portfolio in Denver, a corporate move to the Northeast caused him to transition his holdings into a larger renovation/rental project in his new home city and a Florida vacation rental.

When it became clear that his vacation rental clients were enjoying a lot more sunshine than he was, his family made the move south, and he again relocated his investment dollars. His portfolio has since included single and multifamily long-term rentals, as well as hurricane damaged foreclosures, more vacation rentals, and a commercial building. His current investing focus is on land development and student housing.

The best investment decision Dave ever made has been in spending more time with his family. After just six years as an investor, he was able to use a combination of 1031 exchanges and section 121 primary residence exemptions to generate enough tax-free proceeds for the cash purchase of a sailboat. He lived aboard and enjoyed the adventures of coastal sailing with his family for 10 years.

Now he helps other investors pursue their dreams while he works on a land development project and his four sons finish their academic careers.

Dave has appeared on podcasts such as the Best Real Estate Investing Advice Ever, Landlording for Life, Commit to Wealth, Peer 2 Peer Investing, The Real Estate Syndication Show, Real Estate Nerds, and Can Real Estate Investors Save the World.

Dave is active on the board of the Colorado Online Virtual Academy, the premier college preparatory online charter school in the state of Colorado. A former college basketball player and beach volleyball rat, he was inducted into the Colorado Christian University Athletic Hall of fame in 2007.

Education
Dave earned a B.A. in English, a B.S. in Accounting, and a master’s in Management from Colorado Christian University.

Follow
LinkedIn
The1031Investor.com

As a Guest you have free article(s) left

Join BiggerPockets (for free!) and get access to real estate investing tips, market updates, and exclusive email content.

Sign in Already a member?

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.”

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.

tax strategies book ad

Do you have any other questions about 1031 exchanges? 

Ask me in the comment section below!