Section 1031 exchanges are multifaceted, complex real estate transactions, as we’ve seen from some our previous posts. No matter the particular type, all 1031 exchanges have multiple steps and require a lot of effort to complete successfully without any serious hiccups. Given their complexity, you may think that 1031 exchanges only offer anxiety and a heavy workload to investors. The truth, however, is that there is no reason why any given exchange cannot be smooth, painless, and satisfying.
And even though they do demand plenty of energy, there are bits of charity tucked away in every 1031 exchange. You and other investors will be relieved to know that you are able to use some of the expenses incurred during the course of a 1031 exchange to offset realized and recognized gain. Certain transactional expenses—or “exchange expenses” as we will refer to them here—are inevitable in a section 1031 exchange, and the IRS has wisely taken note of this fact and permits certain expenses to offset gain.
Let’s take a look at some of the most common exchange expenses that may be used to offset your gain or increase the tax basis of your replacement property, along with some expenses that can’t be used for this purpose. In reviewing these expenses, you’ll likely notice that the usable expenses tend to be fees related to the transaction itself, whereas non-usable expenses are generally things that are removed from the transaction and would have been incurred even if the exchange had not taken place.
The logic here is pretty easy to see: Our law gives relief for expenses that are specific to the transaction and denies such relief for general expenses that normally fall on the taxpayer.
Exchange Expenses That Can and Can’t Be Used to Offset Realized and Recognized Gain
Here is a list of common expenses that can be used to either offset your realized and recognized gain or to increase the basis of your replacement property:
- Brokerage commissions
- Messengers fees
- Qualified intermediary fees
- Escrow services fees
- Finder fees
- Inspection, testing, and appraisal fees
- Tax advisor fees
- Notary, filing, and recording fees
- Title insurance premiums
- Documentary transfer taxes
- Legal or consulting fees related to the transaction
As mentioned, these are all secondary fees that arise specifically as a result of the 1031 transaction. They are not “general” fees you would otherwise naturally incur.
Here are some common fees that cannot be used for the purpose of offsetting gain:
- Property taxes
- Fees related to loans (loan fees, loan points, appraisal fees, processing fees, etc.)
- Home insurance premiums
- Security deposits
- Repair and maintenance costs
- Real estate association dues
Neither of these lists are exhaustive, but they give a good sense of allowable and non-allowable expenses. Again, you’ll notice that these non-allowable or non-usable fees generally would be incurred even in the absence of the 1031 exchange.
When you pay the allowable exchange expenses with exchange proceeds, this will not create a tax liability but will instead create an opportunity to either offset gain or reduce your forthcoming tax basis. The authority in this area is a bit limited, and so in some cases, whether an expense is allowable may be subject to case-by-case analysis. Revenue Ruling 72-456, however, provides that brokerage commissions are definitely allowable as exchange expenses, and Private Letter Ruling 8328011 provides for the other transactional expenses mentioned above. You will identify your exchange expenses on IRS form 8824 when you file your tax return.
Paying Non-Exchange Expenses with Exchange Funds May Trigger Constructive Receipt
It’s important to note that not only are non-allowable expenses unable to offset any gain, but also paying these expenses with exchange proceeds may possibly result in your transaction failing to receive 1031 treatment. The IRS may be able to reasonably claim that you had “constructive receipt” of the exchange funds, and this would essentially mean that the transaction had been a sale rather than a 1031 exchange.
Again, it’s difficult to say with absolute certainty what the outcome of any particular case may be. In general, if you pay an expense that is not typically incurred as a normal part of either disposing of your relinquished property or acquiring your replacement property, you run the risk of losing 1031 treatment due to constructive receipt of exchange funds.
Here at CWS Capital Partners, we’re familiar with the ins and outs of exchange expenses, and we’re available to assist with your transaction. When you go through your 1031 exchange, you want to make sure you obtain the best help possible and that means enlisting the services of the right experts. Contact us today to get started.
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