When participating in a 1031 tax-deferred exchange, it is crucial to understand how transactional expenses typically paid at closing are handled. This knowledge helps you avoid unexpected tax liabilities, commonly known as “boot.”
Routine Transactional Costs
Generally, all routine transactional costs associated with the sale of the relinquished property and acquisition of the replacement property can be paid from exchange funds. However, costs related to a mortgage on the replacement property, such as application fees and points, are not considered routine acquisition charges and may result in a taxable event. Always consult with your tax advisor to discuss your specific situation.
Commissions and Professional Fees
- Real Estate Broker’s Commissions: These can be paid from exchange funds as usual.
- Finder Fees and Referral Fees: Also payable from exchange funds.
- 1031 Exchange Fees: Eligible for payment from exchange funds.
- Attorney and Tax Advisor Fees: Fees for work done on the transaction can be covered.
Title Insurance & Related Closing Charges
- Title Insurance Premiums: Can be paid from exchange funds.
- Closing Agent Fees: Document preparation, notary fees, and recording charges are eligible.
- Realty Transfer Taxes or Stamps: Can also be paid from exchange funds.
- Condo Association Fees and Insurance Premiums: These should not be paid from exchange funds as they are operating expenses.
Buyer Credits
When providing a credit to the buyer for closing expenses or needed repairs to the relinquished property, the credit can be paid from the sale proceeds. This is treated as a reduction in 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 to the buyer using sale proceeds without creating a taxable event. The exchanger should bring their 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
Payment of non-transactional expenses, such as utility bills, repair invoices, or credit card bills, from the sale proceeds will create a taxable event since these are not routine closing expenses.
Escrows for Repairs/Outstanding Issues
For funds held in escrow for repairs or outstanding issues, consider the following:
- Constructive Receipt Issues: The escrow agreement should state that any released funds must be paid directly to 1031 CORP., not the exchanger.
- Long-term Escrows: If the escrow is for expenses like back taxes or an outstanding lien and resolution is expected to take longer than 180 days, the exchanger should provide the money from their own pocket. Any reimbursement after acquiring all replacement property is taxable.
Final Advice
Your 1031 CORP. Exchange Officer will request a copy of the preliminary closing statement to review and flag any potential issues before closing. However, you should also be vigilant about these items to ensure a smooth and tax-efficient exchange process.
