What Investors Should Know About 1031 Exchange Closing Costs

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. How a 1031 exchange works is simply by delaying capital gains taxes on the sale of an investment property by reinvesting the sale’s proceeds into a similar property.

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.”

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

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?

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.