An investor’s final settlement statement of a relinquished or replacement property often contains a myriad of expenses. The IRS stipulates that in order for closing costs to be paid out of exchange funds, the costs must be considered normal transactional costs. Given the range and amount of these expenses, investors and their classification are critical in calculating the net value and equity for reinvestment.
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What Might be Classified as Exchange Expenses and Non Exchange Expenses in 1031 Exchange?
Since there is no definitive IRS ruling for the treatment of these exchange expenses the ultimate definition is up to the taxpayer and his/her tax counsel. The American Bar Association Tax Section’s Report on Open Issues in Section 1031 Like-Kind Exchanges (July 14, 1995) classifies payment of closing costs as Exchange Expenses (reduction of boot and increase in basis) and Non Exchange Expenses (taxable as boot) and they read as follows:
YES (Exchange Expenses)
- Sales Commission
- Legal Fees
- Finders Fees
- Escrow Fees
- Inspection/Testing Fees
- Transfer Taxes
- Title Insurance Fees
- Recording Fees
- Property Taxes
NO (Non Exchange Expenses)
- Rent Proration
- Property Liability Insurance
- Mortgage Insurance
- Application Fees
- Lender’s Title Insurance
- Assumption Fees
While the Tax Court in Blatt v. Comm did allow replacement property loan costs as exchange expenses, loan acquisition fees are typically considered to be a cost of obtaining a new loan, not of acquiring the property. Therefore, the same cost may qualify if considered a cost of acquisition and yet not qualify if considered a loan expense.
How Other Transactional Costs in a 1031 Exchange Maybe Treated
Based on the above, other costs you encounter may be treated as follows:
- Exchange or Accommodator Fees
- Messenger Fees
- Document Prep Fees
- Statement Fees
- Tax Service
- Processing Fees
- Notary Fees
- Inspection/Testing Fees
- Home Owners Dues
- Repairs/Termite Work
- Security Deposits
- Replacement Property Loan Acquisition Fees
- Appraisal Fees
Other non-exchange expenses would be treated as they would on any sale closing, expensed or capitalized as applicable.
Hazardous Waste and Property Inspections required by the lender would be loan acquisition costs. If they are requirements of the purchase or sales contract, they become exchange expenses.
It is important for you to analyze the costs to be paid through escrow. Net cash boot is taxable to you even if your new loan is larger than your old loan. If may be worth your while to pay some expenses outside of escrow. Paying less expenses through the escrow leaves more cash for the replacement property, which means you would be looking for a more expensive replacement property or getting a smaller loan. Of course your main goal in the exchange should be to find a good replacement property. Deferment of tax, while a significant element in the economic equation, should not override prudence in selecting a wise investment.
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