1031 Experts - What is Boot and what isn't? Appraisals, Inspection, Surveys, Insurance, RE Tax, Etc?

2 Replies

In the middle of my first 1031.  Of course my 1031 exchanger referred to their attorneys when I asked these questions.  Yes, I will of course ask my tax professional as well.  I am just curious to hear what other 1031 seasoned veterans have done.  Apologies if I use any terminology incorrectly - I have a good understanding, but not so good with the terminology.

PS: my new property will be of greater loan value and property value.  One for one exchange.  I'll be putting 25% down and taking a mortgage.  Funds from the sale of the exchanged property are greater than 25%.  Trying to make sure I do things correctly and not create headaches during tax time, but also have the least amount of out of pocket expenses for the new purchase...

Which of the following are boot?

Appraisals?

Payment of appraisal fees, inspections, surveys and environmental studies are also typically considered taxable boot if they are used to obtain a new loan for the replacement property. If, however, the Purchase and Sale Agreement for the replacement property was specifically made contingent upon the satisfactory completion of these items, the Exchanger could argue that these expenditures were really for the purchase of the property and not to obtain a new loan.

My sale contract states: "This sale IS conditioned on the appraisal of the Property being not less than the Sale Price..." I would argue that the sale agreement is contingent upon the appraisal - this is completely separate from the lender requirements which happen to align with this as well.  However, the bank did order the appraisal - so maybe safer to leave off?

Inspections?

It was not my bank's requirement to have an inspection.  I did this on my own.  Simply an investor doing his due diligence.   I will keep this out of pocket, but I don't buy the argument this can't be included.  My exchanger's handout includes "agreed property inspections" under the non-boot category...

Surveys?

In this case, an elevation cert survey.  Again, I did this out of pocket - not at my banks request - because it is something I would do for any new property - regardless of whether a mortgage or buying with cash.

Insurance? / Tax?

I lump these together because I think they are treated similarly.  I think I understand the following as: you may safely use 1031 Funds to pay insurance premiums and RE tax at closing without repercussions.

Prorated property taxes, insurance payments and rents are usually considered deductible ongoing operating expenses and not part of the exchange, but the payment of these items will not interfere with the safe harbor.

Title Insurance/Closing Fees?

Do not create taxable boot.

Loan Fees/Points/PMI?

Everyone seems to agree that these are taxable boot.  I guess this includes origination fees?

WHAT COSTS CAN BE DEDUCTED?

A frequently asked question is “What expenses can be deducted from the exchange proceeds without resulting in a tax consequence?” Although the IRS has not published a complete list of qualifying expenses, there are some rulings that provide general parameters. Brokerage commissions can be deducted from the exchange proceeds (Revenue Ruling 72-456). Other transactional costs may also be able to be deducted if they are paid in connection with the exchange. (Letter Ruling 8328011).

WHAT ARE “EXCHANGE EXPENSES?”

Transactional costs that are referred to as “exchange expenses” on Form 8824 are not specifically listed but should generally include costs that are:

A.     A direct cost of selling real property, which typically include:

  • Real estate commissions
  • Title insurance premiums
  • Closing or escrow fees
  • Legal fees
  • Transfer taxes
  • Notary fees
  • Recording fees
  • OR -

    B.   Costs specifically related to the fact the transaction is an exchange such as the     Qualified Intermediary fees.

    ITEMS THAT ARE NOT “EXCHANGE EXPENSES”

    Although not a complete list, the costs related to obtaining the loan should not be deducted from the proceeds.

    THESE “NON-EXCHANGE EXPENSES” INCLUDE:

  • Mortgage points and assumption fees
  • Credit reports
  • Lender’s title insurance
  • Prorated mortgage insurance
  • Loan fees and loan application fees
  • OTHER “NON-EXCHANGE EXPENSES” CAN INCLUDE:

  • Property taxes
  • Utility charges
  • Association fees
  • Hazard insurance
  • Credits for lease deposits
  • Prepaid rents and security deposits
  • These rough guidelines do not address every potential cost. Exchangers should review their specific transaction and closing costs with their tax and/or legal advisors.

    @Isaac Isaacson

    A thorny gray area to be sure and I can tell that you see that by the way you even posture the questions.  There is not a lot of guidance from the service on this issue.  What there is is case specific and most not applicable over a broad spectrum.   There are legal experts all over the playing field on this topic.  When does an expense become a cost of sale or purchase or "transactional" expense?  Is it when the cannot go forward if the expense is not made - like an inspection or elevation certificate, or survey?  

    There are aggressive folks who say that any expense required for the purchase to go through is allowable use of 1031 proceeds.  This is where your source who talked about making these things contract contingent was coming from.  That is one argument.

    There  are also folks who like to stay as far away from the edge as possible and any expense other than that charged by the reator, title company, or QI is not allowable.  That is another argument.

    We try to get pre-pays, deposits and discretionary loan fees always  handled outside of closing altogether.  That way there is no question or risk that they in any way become entangled with the 1031.  Other expenses become a question of degree to which they are part of the actual transaction and decision by your legal counsel.

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