Avoid the Boot When Selling your Property
When selling a relinquished property, everyone is relieved to finally get to the closing assuming all of the details have already been taken care of and it is smooth sailing from here. Unfortunately, there are a few potential tax traps lurking on the settlement statement that can eat into your 1031 exchange tax deferral.
Security Deposits and Prepaid Rents
Security deposits and prepaid rent credits are not a routine closing expense and can create a taxable event when paid from the Exchanger to the Buyer using sale proceeds. To avoid a tax liability, the Exchanger can bring his own funds to the closing table to cover these expenses and they can be shown on the closing statement as Paid Outside Closing (P.O.C.).
Some Exchangers ask the closing agent to pay expenses from the sale proceeds that are not routine transactional expenses, such as the last electric bill, invoice for recent repairs and even credit card bills. Payment of these expenses will create a taxable event for the Exchanger and we encourage our Exchangers to exclude these expenses from the closing statement.
Escrows for Repairs/Outstanding Issues
If funds must be held in escrow for repairs or outstanding issues, there are several things that must be considered. The escrow agreement should state that any funds released from escrow should be paid directly to 1031 CORP. and not the Exchanger. This will preserve the Exchanger’s ability to use these funds for their replacement property and avoid capital gains on them. If the escrow is for an expense, such as back taxes or an outstanding lien, and will take quite a while to disburse or will disburse after the replacement property is acquired, ideally the Exchanger should put up the money from his own pocket to be held in escrow to prevent creating a taxable event.
Our Exchange Officers strive to review closing statements in advance of closing to look for potential tax traps, such as these, and bring them to your attention. Our goal is to help you maximize your tax deferral while keeping the exchange process simple for you.