Navigating Closing Costs and the 1031 Tax Deferred Exchange

By James Brennan, Exchange Solutions Group L.L.C.

Often the assumption is made that closing costs will be subsidized by 1031 Exchange proceeds. However, while some of these costs certainly can be bankrolled by the tax deferred exchange, some cannot. Knowing the difference can keep your transaction out of hot water.

C-Level executives cannot get by utilizing back-of-the-envelope numbers when evaluating commercial real estate transactions. That it why it is extremely important to understand the tax implications with regards to closing costs in the context of a like-kind exchange. Often the assumption is made that closing costs will be subsidized by 1031 Exchange proceeds. However, while some of these costs certainly can be bankrolled by the tax deferred exchange, some cannot. Knowing the difference can keep your transaction out of hot water.

It is generally acknowledged that payment of brokerage commissions from exchange proceeds does not create taxable boot. Thus, payment of these non-recurring costs of sale or purchase from the exchange proceeds should not be considered taxable boot. Brokerage commissions are one example of non-recurring costs.

Allowable non-recurring costs are as follows:

– Real estate commissions
– Recording fees
– Direct legal fees
– Title insurance premiums
– Qualified intermediary fees
– Agreed property inspections
– Escrow or closing agent fees
– Documentary transfer fees

Note: Expenses have to be customary in the jurisdiction (e.g. 6 percent listing agreement).

Un-Covered Costs:

Certain costs are generally not covered under Section 1031 regulations and are considered taxable boot. The issue most people run into involves getting a new loan on the replacement property. Because the costs for acquiring the new loan are not related to the acquisition of the replacement property (according to the IRS), they are considered taxable boot.

These include:

– Loan fees
– Points
– Prorated mortgage insurance

Another issue to consider is that prorated property taxes, insurance payments and rents are considered deductible ongoing expenses. As such, they are not included as part of the 1031 Exchange proceeds; however, their payment does not impact the use of the Qualified Intermediary safe harbor. Most of the time attorneys select to handle prorated rents and property taxes in a separate agreement outside the purchase and sales agreement and off the HUD-1.