Avoiding Taxable Boot in a 1031 Exchange Closing
Tips to Prevent an Unexpected Tax Bill
We’ve all sold properties and are tempted to postpone paying expenses until closing when we can have the closing officer put them on the closing statement and just pay them from the sale proceeds. Unfortunately, when effecting a 1031 tax-deferred exchange, anything other than routine closing costs could trigger a taxable event.
The Qualified Intermediary (QI) will provide the closing officer with instructions to make sure the transaction is documented as a 1031 exchange and not a taxable sale. Whenever possible, the QI always tries to review the closing statement prior to closing to address any potential red flags in advance of closing. More importantly, the QI wants to make sure the Exchanger does not receive or have rights to any of the exchange funds either directly or indirectly which create a taxable event.
Here are some tips to help you avoid an unexpected taxable event because of charges paid with 1031 exchange funds:
Commissions and Professional Fees: Real estate broker commissions, finder fees and other referral fees can be paid from exchange funds as normal. Exchange funds can also be used to pay the 1031 exchange fees as well as attorney and tax advisor expenses for work done on this transaction.
Title Insurance & Related Closing Charges: Exchange funds can be used to pay for title insurance premiums and related closing agents fees, such as document preparation, notary fees and recording charges. Realty transfer taxes or stamps can also be paid.
Hazard Insurance and Homeowner’s Association Fees: Condo association fees and fire, casualty and liability insurance premiums should not be paid from exchange funds as they are operating expenses.
Security Deposits and Rent Pro-Rations: These are not closing costs but a transfer of funds related to your rental business. These should be paid with additional funds brought to the closing table.
Funds Held in Escrow: Occasionally, the closing officer must withhold some of the proceeds for a repair or an outstanding item such as a past mortgage payoff that was not satisfied or a possible tax lien. If the escrow is expected to be for a short time and the escrow funds will be released before the replacement property is scheduled to be acquired, the escrow agreement should state that all remaining funds be paid directly to the QI and not the Exchanger. If the escrow may take quite a while to disburse or will definitely disburse after the replacement property is acquired, the Exchanger should put up the money from his own pocket to be held in escrow to prevent creating a taxable event. Any reimbursement made after the Exchanger acquired all replacement property can be paid directly to Exchanger as the 1031 exchange is already completed. Any reimbursement paid directly to Exchanger during the exchange is taxable.
Non-Resident Withholding: Some states have a Non-Resident Withholding Tax that must be paid when recording a deed. While most states have an exemption one could request when exchanging, if 1031 exchange funds are used to pay this withholding, it will likely create a taxable event. Learn more on non-resident withholding taxes. Learn more about non-resident withholdings.
Buyer Credits: There are many situations when the Exchanger is asked to provide a credit to the Buyer. The credit may be to help cover closing expenses or for needed repairs to the relinquished property. The credit can be paid from the sale proceeds and is treated as a reduction to the sale price and does not create a taxable event for the Exchanger.
Mortgage Related Fees: Costs associated with a placing a mortgage on the replacement property, such as application fees and points, are not considered routine acquisition charges and may create a taxable event.
Appraisals and Environmental Studies: While many lenders require these in order to secure financing, unless the sales contract specifically requires the appraisal or environmental study, the cost cannot be paid from exchange funds. If the contract does not require them but the lender does, these are typically deemed a mortgage expense and may be subject to tax if paid from exchange funds.
Non-Transactional Expenses: Some Exchangers ask the closing agent to pay a variety of expenses from the sale proceeds that are not 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 as they are not a routine closing expense.
Role of the Qualified Intermediary (QI)
While 1031 CORP. does sign the closing statement as QI, it is up to the Exchanger to review and approve the charges. In all cases, you would discuss your transaction expenses with your tax advisor to determine what is best in your situation.