A 1031 exchange, like all financial transactions, has costs associated with its closing—fees, premiums, and expenses that include everything from security deposits to messenger service bills. Managing these costs is one of the most complex aspects of a 1031 exchange. When possible, it’s preferable to roll them into the cost of the exchange property, rather than paying them out of pocket. But, incorrectly rolling closing expenses into an exchange can have a disastrous effect on the deal. Thus, extreme caution is necessary when deciding how to pay them.
Not All 1031 Exchange Closing Costs Are the Same
The greatest difficulty in deciding which costs can be paid with exchange money is the lack of guidance. IRS Tax Form 8824 illustrates this problem in that it explicitly allows “exchange expenses” to be paid from exchange funds, but the filing instructions provide no definition of those expenses. The treatment of broker commissions as exchange expenses has been codified in IRS Revenue Ruling 72-456. Tax professionals have come to a rough consensus on how to handle other closing costs based on their interpretations of disparate IRS and Treasury Department documents.
Miscategorizing those expenses can result in boot—property, including cash, that cannot be included in the like-kind exchange and is therefore subject to taxation. Generally, the following outlays are considered exchange expenses:
- Owner's title insurance premiums
- Escrow and settlement fees
- Real estate broker commissions
- Finder fees
- Qualified Intermediary fees
- Documentary transfer taxes
- Notary and filing fees
- Legal and tax advisor fees related to the exchange
- Messenger expenses
Examples of costs that are not considered exchange expenses include:
- Loan costs, such as appraisal fees, mortgage insurance premiums, lender's title insurance policy premiums, and processing fees
- Prorated rents, property taxes and utilities
- Security deposits
- Repairs or maintenance costs
Worse, there are instances when the IRS can consider the use of exchange funds to pay certain costs to be constructive receipt. That is, the IRS can determine you have control over that money, which makes it taxable, even if you are not in possession of it. Treasury Regulation Section 1.1031(k)-1(g)(6) and (7) permits the use of exchange funds for “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 statement as the responsibility of a buyer or seller (e.g., commissions, prorated taxes, recording or transfer taxes, and title company fees).” Under that regulation, other uses can constitute constructive receipt, which can disqualify the entire transaction, as it means that the deal is no longer purely an exchange.
As an extra cautionary measure against a finding of constructive receipt, the qualified intermediary that accommodates the exchange will often wait until after the deal has closed before paying any expenses with exchange funds.
While a 1031 exchange is an appealing opportunity for investors looking for a tax-deferred investment option, the treatment of closing costs is just one example of why professional advice is critical when making the exchange. If you are interested in a 1031 exchange and want to explore its possibilities further, consult a trusted real estate investment management firm.
To find out more about the 1031 exchange process, read our blog articles on the subject.
At CWS Capital Partners, we have more than 30 years of experience helping our clients navigate 1031 exchanges.
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