Why Navigating 1031 Exchanges Is a Slippery Slope
1031 exchanges are powerful tax tools, but they require careful planning and timing. Small missteps such as using Exchange funds for the wrong kind of closing costs can create taxable “boot” that will cut into the tax benefits of your 1031 Exchange. Planning ahead, documenting carefully and working with an Exchange professional from the beginning is paramount to ensure a smooth Exchange.
What Closing Costs Are Generally Accepted as Normal Transactional Costs?
There is currently no list which definitively explains which closing costs count as “normal transactional costs.” Like in many tax-related situations, things are not black and white. Many closing costs land in a gray area based on the details of your situation, so you should always discuss costs with your tax advisors. However, the following list of costs are generally treated as normal transactional costs when selling property:
- YES: Commonly accepted transactional costs
- Sales commissions
- Legal fees
- Finder’s fees
- Escrow fees
- Inspection and testing fees
- Transfer taxes
- Title insurance fees
- Recording fees
- Property taxes
There are also many items that are typically not considered normal transactional costs:
- NO: Not considered normal transactional costs
- Rent prorations
- Utilities
- Property liability insurance
- Loan points
- Mortgage insurance
- Application fees
- Lender’s title insurance
- Assumption fees
- Homeowners dues
- Repairs
- Termite work
- Security deposits
- Replacement Property Loan Acquisition Fees
These items tend to fall in between and depend on your circumstances:
- MAYBE: Depends on the situation and timing
- Exchange or combination fees
- Messenger fees
- Document preparation fees
- Statement fees
- Inspection/testing fees
- Tax service fees
- Processing fees
- Notary fees
- Appraisal fees (see below)
The Appraisal Fee Gray Area
An appraisal fee often looks like it should be an accepted cost, but its treatment can change based on why it was done. If the appraisal is tied to financing (you needed the lender to make the loan), many tax pros consider it part of the financing and not a deductible transactional cost. If the appraisal was a contingency of the purchase/sale itself, it’s more likely to be treated as a normal transaction cost. Talk this through with your tax advisor before making any assumptions.
Pulling Cash Out Before Closing: When It Becomes “Boot”
Imagine for a moment that you spent a lot of money prepping a property for sale (repairs, upgrades, staging) and you want to recoup those costs at closing. If you spend $50,000 getting the property ready and then pull $50,000 out of the sale proceeds, that cash is typically treated as taxable boot in a 1031 exchange. Why? Because you’ve effectively reduced the value you’re exchanging into replacement property and taken taxable proceeds instead.
There are two possible ways to handle this legally:
- Place a lien on the property to secure the improvements. The lien must be valid and should be held by a party other than you (e.g., a vendor or lender). Importantly, the lien should be placed well in advance of listing the property so it doesn’t look like a contrived “step transaction.” The lien must be seasoned (established and documented) so it’s not seen as created solely to avoid tax consequences.
- Accept the taxation and treat the $50,000 as boot, then work with your tax advisors to offset or mitigate the tax. That might mean expensing certain costs or using other tax planning strategies to reduce overall tax owed.
Capital Improvements vs. Expenses: What to Consider
Every dollar you put into a property is either:
- Expensed (written off now), or
- Capitalized (added to basis and reduces future taxable gain)
Common improvements that are capitalized include structural fixes, roof replacement, kitchen remodels, etc. Routine repairs and maintenance are often expensed. But timing matters: if you capitalize an improvement and then immediately pull that money out at closing without a lien or other secure method, that dollar may still functionally create boot.
Tax Exposure vs. Actual Tax Owed
It’s important to know that having tax exposure is not the same as owing taxes immediately. Should you slip up or choose to do something that exposes you to tax liability on a transaction, you may still be able to sit down with your advisors later and see if you have losses elsewhere that would offset that tax. You don’t have to chase a perfect, completely tax-free Exchange.
“1031 is not all or nothing. Do what’s gonna be right for you. Don’t make your life real hard and just say, ‘I have to hit these numbers, otherwise it just doesn’t make sense.'”
There are many transactions where money does go towards something that’s not a normal transactional cost. And that’s okay, it will not kill your Exchange. In fact, it may actually make your life easier. And if it does, pay the tax on that difference. Then you can go to bed knowing you’re going to sleep well at night instead of worrying about your Exchange.
Practical Checklist Before You Sell in a 1031 Scenario
- Document all improvement costs and keep receipts.
- If you need to recoup pre-sale expenditures, consider recording a lien that is valid and properly seasoned.
- Determine whether expenditures are repairs (expense) or capital improvements (capitalize).
- Discuss appraisal fees, lender fees, and who pays what at closing with your tax advisor ahead of time.
- Plan for boot possibilities and identify potential offsets (losses, expensing other items, timing).
- Work with a qualified intermediary and involve legal and tax counsel early.
Final Recommendations
1031 Exchanges offer many benefits, but they are complex and require in-depth planning with tax and legal advisors to see the results you are looking for. To ensure your Exchange goes smoothly, always:
- Plan early: don’t make last-minute fixes without considering tax consequences.
- Document everything and season any liens or financing arrangements so they stand up to IRS scrutiny.
- Remember many closing costs fall into gray areas: appraisal fees and some processing fees are party-dependent, and only your tax/legal advisors can help you assess your situation.
- Consult your tax and legal advisors every step of the way: advisors should be part of your planning from the beginning. They will help you navigate all of your planning to minimize and mitigate tax exposure and reap the best benefits for your Exchange.
Need Help?
If you have questions about closing cost deductions, capital improvements, or avoiding boot in a 1031 Exchange, feel free to reach out to Equity Advantage. Visit 1031Exchange.com or contact your tax and legal advisors and bring this checklist with you so you can hit the ground running.
The Guys With All The Answers…
David and Thomas Moore, the co-founders of Equity Advantage & IRA Advantage
Whether working through a 1031 Exchange with Equity Advantage, acquiring real estate with an IRA through IRA Advantage or listing investment property through our Post 1031 property listing site, we are here to help Investors get where they want to be. Call them today! 503-635-1031.
