Transactional Expenses and 1031 Exchange Proceeds

Posted by Margo McDonnell | Tue, Sep 11, 2012

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Our Tuesday’s Tip addresses how transactional expenses typically paid at closing are handled in a 1031 tax-deferred exchange to avoid an unexpected tax liability known as “boot.” 

Typically all routine transactional costs associated with the sale of the relinquished property and acquisition of the replacement property can be paid from exchange funds. Costs associated with a mortgage on the replacement property, such as application fees and points, are not considered routine acquisition charges and may create a taxable event. It is always recommended to discuss your situation with your tax advisor. 

Commissions and Professional Fees

Real estate broker’s 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. Condo association fees and fire, casualty and liability insurance premiums should not be paid from exchange funds as they are operating expenses. 

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.  

Security Deposits and Prepaid Rents

Security deposits and prepaid rent credits cannot be paid from the Exchanger to Buyer using sale proceeds without creating a taxable event. The Exchanger should bring his own funds to closing to cover these expenses and they can be shown on the closing statement as Paid Outside Closing (P.O.C.). 

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. 

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. To avoid constructive receipt issues, the escrow agreement should state that any funds released from the escrow account must be paid directly to 1031 CORP. and not Exchanger. If the escrow is for an expense, such as back taxes or an outstanding lien, and is expected to take longer than 180 days to be resolved, the Exchanger should put up the money from his own pocket to be held in escrow.  Any reimbursement made after the Exchanger acquired all replacement property is taxable.

Your 1031 CORP. Exchange Officer requests a copy of the preliminary closing statement to review and raise any flags prior to closing but you should also be on the lookout for these items.

Topics: 1031 exchange rules, 1031 exchange closing costs

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