What Closing Costs are Considered Allowable 1031 Exchange Expenses?

It is permissible to use some of your sales proceeds for exchange-related expenses, but certain costs can’t be included, and may affect your 1031 tax deferral equation.

In a Section 1031 like-kind exchange, a property owner can defer taxes on the sale of one property by purchasing a like-kind property. The amount of gain that can be deferred depends on the value of the replacement property: to fully defer all gain on the relinquished property sale, the value of the replacement property must be equal to or greater than that of the relinquished property less any permissible closing costs, whereas the full sales proceeds are used to acquire the replacement property and the debt is replaced.

While that is the ideal scenario, actual property sales are more complicated, involving mortgages, closing costs, and various service providers who take part in executing the exchange.

These additional expenditures can alter the exchange equation because some costs associated with a 1031 exchange can be paid for with exchange funds, while some cannot. Without guidance, figuring out which expenses can and cannot be paid for with your sales proceeds can be difficult.

Rules outlining valid and invalid 1031 exchange expenses

IRC Section 1031 does not contain a list of qualifying exchange expenses. Instead, we have to rely on IRS rulings that outline the types of expenses that have been considered permissible. These rulings are not exhaustive, but they do offer general parameters for common expenses.

Revenue Ruling 72-456 concerns brokerage commissions, stating: “money paid out in connection with an exchange under section 1031 of the Code is offset against money received in computing gain realized and gain recognized and is also added in determining the basis of the acquired property.”

Generally speaking, exchange funds can be used to pay brokerage commissions without invalidating an exchange. The ruling goes through several examples, the simplest of which is this:

Situation 3. A taxpayer exchanged his property, land held for productive use in trade or business or for investment, with an adjusted basis of $10,000, for property of a like kind, to be held for productive use in trade or business or for investment, with a fair market value of $20,000. He paid a commission of $2,000 to a real estate broker.

The $2,000 broker commission is an allowable exchange expense. This commission is added to the adjusted basis of the relinquished property, so that the adjusted basis of the replacement property is now $12,000.

What expenses can be paid for with sales proceeds during a 1031 exchange and still be eligible for tax deferral?

Additional IRS rulings and case history have left us with a non-exhaustive list of expenses and liabilities that are usually considered permissible exchange expenses. These include:

1. Brokerage commissions
2. Closing fees
3. Exchange fees paid to the Qualified Intermediary
4. Attorney’s fees
5. Tax advisor fees
6. Escrow agent fees
7. Transfer taxes and notary fees
8. Title insurance premiums
9. Filing fees or recording fees
10. Environmental studies, appraiser’s fees, and due diligence (if related to the acquisition and not a requirement of a lender)

This does not mean that expenses falling under these broad categories are allowed in every situation. For example, if you execute a number of real estate transactions and keep an attorney on retainer, you can’t pay for all of your legal fees with exchange funds. The same goes for your accountant – only the work they did on the exchange is deductible.

What exchange expenses are not deducible under IRC Section 1031?

Non-permissible exchange expenses generally fall into two categories: those that result in taking constructive receipt of funds and those that don’t. Using exchange funds for costs unrelated to the sale or purchase of exchange property may trigger constructive receipt and invalidate the exchange, so it’s critical to avoid using exchange funds for unrelated costs.

The types of expenses that can trigger constructive receipt include anything that does not typically appear on a closing statement. Whether or not an expense is “typical” is based on local standards, meaning this might vary based on where you live. The following are generally disallowed in most instances:

1. Property taxes
2. Mortgage points and assumption fees
3. Utility charges
4. Association fees
5. Credit reports
6. Security deposits
7. Insurance premiums

The second category of disallowed expenses includes those that are taxable, but do not trigger constructive receipt. According to Treas. Reg. 1.1031k-1(g)(7), this includes “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 statements as the responsibility of a buyer or seller.”

Items generally considered taxable are:

1. Prorated rents
2. Transfer taxes
3. Title company fees
4. “Personal property incidental to the like-kind real property received” (For more see the instructions for IRS Form 8824)

Paying these things with exchange funds won’t necessarily invalidate an exchange, but doing so could result in a taxable boot. For example, if prorated rents are paid to the buyer of the relinquished property, that amount would be taxable if paid out of exchange funds or by giving the buyer a credit in that amount. If the exchanger instead pays these costs separately using outside cash, full tax deferral would still be possible.

The same is true of costs related to obtaining a loan to acquire the replacement property, as these are considered loan costs, not purchase costs. That can include loan application fees, prorated interest, processing fees, and appraisal costs (if required by the lender). Expenses related to failed acquisitions may also be taxable.

How to achieve full tax deferral under Section 1031

When performing an exchange, the goal is to defer all taxes related to the relinquished property sale. In order to do that, you will not only have to avoid using exchange funds for expenses that might trigger constructive receipt, but also those that will result in a taxable boot. Adding additional cash brought to closing can cover these costs and ensure that exchange funds are not used for them.

The uncertainty over these rules is why it’s important to work with trusted legal and tax advisors who can guide you through this process. It’s also important to work with a Qualified Intermediary that protects your funds. Since the use of exchange funds for disallowed expenses can trigger constructive receipt, an incorrectly sent payment made without your consent could cause your exchange to fail.

That’s why JTC requires dual authorization for any release of exchange funds. No funds will be used for any purpose without the approval of both the exchanger and JTC, ensuring that you can check if an expense is allowed before releasing payment. Working with an experienced QI that utilizes industry best practices is the best way to ensure your exchange is set up for success.

Click the link below to learn more about why choosing a QI based on price or proximity can come back to haunt you: