Closing costs in a 1031 exchange
In every tax-deferred exchange there are fees, costs and expenses incurred in handling the transaction. Some are expenses directly associated with structuring and transacting the exchange. Others are typical closing costs that occur on any transfer of property. Still others are costs and prorations which account for the period of time that the exchanger and buyer own a property during a month or year and “square up” the exchanger and buyer for their period of ownership. Handling these expenses in a certain way will result in the exchange being partially taxable.
Certain expenses paid at a closing are considered “exchange expenses” and using exchange funds to pay those expenses won’t result in any tax liability to an investor doing a 1031 exchange. For example, Revenue Ruling 72-456 provides that if exchange funds are used to pay broker’s commissions, it does not result in the transaction being partially taxable. There are no other clear rulings on this subject, but most tax advisors agree that the following expenses are exchange expenses and may be paid at the closing of the relinquished or replacement properties without any tax consequence:
- Broker's commissions
- Exchange fees charged by the Qualified Intermediary
- Title insurance fees for the owner’s policy of title insurance
- Escrow fees
- Appraisal fees required by the purchase contract
- Transfer taxes
- Recording fees
- Attorney’s fees incurred in connection with the sale or purchase of the property
- Accounting fees for structuring the exchange transaction
Other expenses are not exchange expenses, so although exchange funds can be used to pay the expense, doing so results in the exchange being partially taxable. For example, security deposits and prorated rents are not considered exchange expenses and if exchange funds are used to pay them, the exchange will be partially taxable. This comes up when the seller of the relinquished property gives the buyer a credit at the closing for the security deposits and prorated rents. The result of the credit is as if the seller was using exchange funds to pay the security deposit and prorated rent amounts to the buyer. To avoid the tax, the seller should deposit his own funds to pay those security deposits and prorated rents to the buyer.
In addition, fees and costs in connection with getting the loan to acquire the replacement property are costs of the loan, not costs of purchasing the replacement property, and therefore under tax law are not exchange expenses. If the investor uses exchange funds at the closing of the replacement property to pay loan costs and fees, doing so will create a tax liability. To avoid the tax liability, the buyer may want to deposit his own funds to pay any loan related expenses.
Some non-exchange expenses create a tax liability but are offset by a deduction. One example of this is property taxes. Although property taxes are not an exchange expense, the investor will get a deduction for paying the property taxes and so the liability will be offset by the deduction.
The following is a list of expenses that are typically found on a closing statement but are generally not considered exchange expenses:
- Loan costs and fees
- Title insurance fees for lender’s title insurance policy
- Appraisal and environmental investigation costs that are required by the lender
- Security deposits
- Prorated rents
- Insurance premiums
- Property taxes
In most instances, the issue of payment of nonexchange expenses is a small one compared to the overall tax deferral on the property exchange. To the extent that the exchanger has outside cash available and pays attention to these details and is properly advised, the exchanger can optimize tax savings on the exchange.
If you have any questions regarding structuring such an exchange, contact Kenneth Zacharias at 920-455-4207, or ask for any member of the Schenck Real Estate & Construction team.
Kenneth Zacharias, CPA, has a broad background in income tax and general business consulting. He has extensive experience in taxation issues concerning real estate, including like-kind exchanges, use of partnerships and LLCs, construction and developer issues, and capital gains planning.