In a 1031 exchange, not all closing costs are created equal. Certain expenses can be covered with exchange proceeds without triggering tax consequences, while others are better handled outside the exchange.
What is a 1031 Tax-Deferred Exchange you may ask? An IRC 1031 Exchange permits you to sell property without paying tax on the gain of the sale, if you replace the property by following the rules. Simply, a 1031 Tax-Deferred Exchange is the process of deferring the payment of taxes when selling investment property to a later time by investing the proceeds from the sale of one investment property into the purchase of another.
Using exchange funds for the wrong type of expense can result in unintended taxable boot. Although the IRS has never issued a definitive list, the general rule is that costs directly tied to the sale or acquisition—and to the exchange itself—are more likely to be permissible.
Costs Generally Treated as Exchange Expenses. These may often be paid from exchange proceeds:
– Real estate commissions
– Title insurance premiums
– Closing or escrow fees
– Legal fees
– Transfer taxes and notary fees
– Recording fees
– Qualified intermediary fees
Costs Generally Not Treated as Exchange Expenses. These should generally not be paid from exchange proceeds:
– Loan fees, points, and application fees
– Credit reports
– Lender’s title insurance
– Property taxes
– Utility charges
– Association fees
– Hazard insurance
– Rent prorations, security deposits, and lease deposits
Prior to closing, it is wise for investors to go line-by-line through the settlement statement with their tax advisor, closing agent, and qualified intermediary. Clarifying which items qualify as exchange expenses—and which do not—can help avoid surprises.
A successful 1031 exchange involves more than meeting deadlines and acquiring replacement property. Careful attention to how closing costs are handled can make the difference between full tax deferral and an unexpected tax bill. My friend and colleague, Greg Lehrmann, owner of ExceLehrmann 1031 is an excellent source for guidance and information regarding 1031 exchanges. Seeking advice Greg would be a great first step.