What Are 1031 Exchange Closing Costs? What Are 1031 Exchange Closing Costs?
A 1031 exchange is an innovative option for real estate investors to defer capital gains tax on property transactions by selling an investment property and using the proceeds from the sale to purchase a like-kind replacement property. Section 1031 of the U.S. Tax Code provides investors with an invaluable path to potential wealth building.
Key Takeaways:
- Many expenses are paid at a closing. Some are considered exchange expenses.
- Using exchange funds to pay for exchange expenses will not result in a taxable event for an investor doing a 1031 exchange.
- Other expenses are not typically considered exchange expenses because they do not directly relate to the disposition of the relinquished property or the acquisition of the replacement property.
The 1031 exchange process is understandably complicated, which makes working with a Qualified Intermediary like Leader1031 all the more important. One of the more common questions investors have about 1031 exchanges is what can be classified as a closing cost on the transaction. Below, we'll get into some examples of what is allowable and unallowable expenses at closing in a 1031 exchange. Let's get into it!
What is Classified as a Closing Cost in a 1031 Exchange Transaction?
Many expenses are paid at a closing. Some are considered exchange expenses. Using exchange funds to pay those expenses will not result in a taxable event for an investor doing a 1031 exchange, whereas others are not.
Generally, expenses that are directly related to the disposition of the relinquished property or the acquisition of the replacement property may be paid using exchange funds without resulting in a taxable event for an investor.
Exchange expenses reduce the sales price and reveal the number we classify as net exchange proceeds. The net exchange proceeds indicate the cash amount needed to be utilized for full tax deferral in a 1031 exchange. Net + debt = Full tax deferral on the replacement property purchase.
What Closing Costs Are Considered Exchange Expenses?
Certain expenses paid at a closing are considered exchange expenses. Using exchange funds to pay those expenses will not result in a tax liability for an investor doing a 1031 exchange. For example, Revenue Ruling 72-456 provides that if exchange funds are used to pay brokerage commissions, it does not result in the transaction being partially taxable. There are no other clear rulings on this subject, but most tax advisors agree that the following expenses are exchange expenses and may be paid at the closing of the relinquished or replacement properties without any tax consequence:
- Brokerage commissions
- Exchange fees
- Transfer taxes
- Escrow fees and recording fees
- Title insurance fees for the owner's policy of title insurance
- Attorney or escrow fees incurred in connection with the sale or purchase of the property
What Closing Costs Are Considered Not Allowable?
The following expenses are often found on a closing statement but are typically not considered exchange expenses because they do not directly relate to the disposition of the relinquished property or the acquisition of the replacement property:
- Loan costs and fees
- Utility charges and association fees
- Title insurance fees for the lender's title insurance policy
- Appraisal and environmental investigation costs that are required by the lender
- Prorated rents
- Hazard insurance
- Credits for lease deposits
- Property taxes
How to Get Started With a 1031 Exchange
Whether you have specific questions about closing costs in an exchange or you're just wondering how to get started, the first step to take when exploring the benefits of a 1031 exchange is to ensure you've surrounded yourself with the appropriate team of professionals to guide you through the process including a tax advisor, real estate agent, attorney, and Qualified Intermediary.
Finding the right Qualified Intermediary to work with is crucial to the 1031 exchange process because it helps verify the security of your funds and provides your entire team with knowledge and experience that they might not otherwise have.
Your Qualified Intermediary will interact with your realtor, tax advisor, escrow professional, attorney, and representatives for the property you are purchasing, so it's extremely important to make sure you choose a QI who can guide your team through the complexities of the process while meeting all of the important associated deadlines.
Leader Bank's 1031 exchange subsidiary, Leader1031*, serves as a Qualified Intermediary for real estate investors seeking to sell and purchase property using the tax-deferred advantages of a 1031 exchange. These services provide greater integration and efficiencies for our commercial real estate clients, and Leader1031 is committed to providing the highest quality of service.
As soon as your relinquished property has gone into contract, you can set up a 1031 Exchange account with Leader1031. This 1031 Exchange account and certain documentation provided by your QI must be in place prior to the close of your relinquished property sale.
Leader1031 is ready to help ensure your transactions are in full compliance with IRS Code Section 1031. Contact Leader1031 today!
It is imperative that you also consult with your own tax and legal counsel. Leader1031 is prohibited from providing tax and legal counsel as a qualified intermediary under the IRS Code Section 1031.
The content of this publication is provided as general information only and should not be taken as legal, investment or other professional advice. This content of this publication shall not be construed as a recommendation to participate in any particular trading, financial or investment strategy, and neither Leader Bank, NA nor Leader1031.com, LLC can provide legal or tax advice concerning the specific tax consequences of a given transaction. Any action that you take as a result of information or opinions provided in this publication is ultimately your responsibility. Consult your attorney, accountant, or tax professional before making any investment or financial decisions. To ensure compliance with requirements under Treasury Department Circular 230, we inform you that the contents of this publication are not intended or written to be used, and may not be used, for the purpose of (i) avoiding U.S. federal tax penalties or (ii) promoting, marketing, or recommending to another party any matter addressed herein. Each taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax adviser.
