When selling or purchasing an investment property in a 1031 exchange, certain selling expenses paid out of the sales or 1031 exchange proceeds will result in a taxable event for the exchanger. Routine selling expenses such as broker commissions or title closing fees will not create a tax liability. Operating expenses paid at closing from 1031 proceeds will create a tax liability for the exchanger.
The IRS, through various revenue rulings has provided guidelines for allowable and unallowable closing and settlement costs based on common geographical practices and standards.
Allowable vs. Nonallowable Closing Costs
Intermediaries, attorneys and other 1031 specialists have a rough idea of the costs which will be classified as allowable in an exchange. Conversely, they also have a rough sense of which costs are regarded as nonallowable. Here are some of the allowable costs:
- Escrow fees
- Title insurance fees
- Real estate broker’s commissions
- Appraisal costs (for purchase contract exclusively)
- Attorney’s fees related to the sale
- Recording fees
- Excise or transfer taxes
- Prorated taxes
- Qualified intermediary fees
Because these fees are considered allowable, the taxpayer will not incur a tax liability if they’re paid with exchange proceeds. In turn, this means they won’t affect the target price of the replacement property to create full tax deferral. Suppose that a given taxpayer conducts a 1031 exchange and incurs $50,000 of allowable closing costs. When the taxpayer uses exchange proceeds to pay $50,000 toward these costs, this sum will not need to be recaptured on the price of the replacement property to avoid taxable boot
Non-Allowable Exchange Closing Expenses
Other common closing costs that are NOT exchange expenses can result in tax liability if they are paid with 1031 proceeds. For example, security deposits and prorated rents for the sale of exchange property that are paid with 1031 proceeds WILL create a taxable event. To avoid this, have the security deposits and pro-rated rents paid outside of closing, or funded directly by the seller at closing.
Common NON-allowable closing costs which are listed on a settlement statement include:
- Costs related to financing
- Prorated rents
- Security deposits
- Property taxes
- Insurance premiums
- Appraisals required by a mortgage lender
- Environmental checks required by a lender
- Other mortgage related costs (application fees, points, etc.)
- Non-transactional costs (utility bills, credit card bills, etc.)
Non-allowable closing costs, however, will create a taxable event. Let’s assume that a given taxpayer incurs $25,000 of non-allowable closing costs in an exchange. If they’re paid using exchange proceeds, they’ll be treated as boot from the exchange and thus be subject to tax. From a tax perspective, it’s like the taxpayer took $25,000 of boot from the exchange and then paid these expenses. This means that the taxpayer will incur a liability based on the $25,000.
Get Experienced 1031 Exchange Help
Again, the optimal course of action will always depend on the specifics of the situation. If the taxpayer is in a higher income tax bracket, paying closing costs with exchange proceeds may be desirable. At Sera Capital, we understand that the complexity of 1031 like kind exchanges can be overwhelming. That’s why we make it a priority to break things down in the simplest way possible. If you need counsel on an upcoming 1031 transaction, please reach out.