When dealing with 1031 exchanges, closing costs can be a tricky area. Exchangers often want to cover their closing costs using 1031 exchange funds without triggering a taxable event. The IRS allows certain closing costs to be paid with these proceeds without compromising the exchange, while others are taxable.
For example, according to IRS Revenue Ruling 72-456, paying a broker’s commission with exchange funds won’t jeopardize a 1031 exchange.
Here’s a rundown of specific exchange expenses that most tax advisors agree are permissible:
Title insurance fees
Escrow, title company, or attorney fees related to the sale or purchase of property
Recording or filing fees
Excise and transfer taxes
The Qualified Intermediary’s exchange fee
Appraisal fees required by the purchase contract
Tax advisor fees related to the sale or acquisition of property
Broker commissions, as previously mentioned
However, using 1031 proceeds for certain other closing costs can lead to tax liabilities. For instance, if security deposits and prorated rents are paid with 1031 proceeds during the sale of exchange property, it will create a taxable event. To prevent this, these costs should be paid outside of closing or directly funded by the seller at closing
Common non-allowable closing costs listed on a settlement statement include:
Costs related to financing, such as:
Loan costs
Application fees
Points
Other lending fees
Title insurance fees for the lender’s title insurance policy
Property taxes
Insurance premium payments
Appraisals required by a mortgage lender
Environmental checks required by a mortgage lender
Mortgage loan reserve amounts
Non-transactional costs, such as:
Utility bills
Association fees
Credit card bills
Security deposits
Prorated rents
To avoid tax liability, buyers should use their own funds to pay any loan-related expenses. Additionally, some non-allowable expenses that create a tax liability can be offset by tax deductions. Property taxes, insurance premiums, and utility bills are all deductible rental expenses.
Another common issue arises when an exchanger wants to use exchange funds to pay loan lock-in fees or loan application fees before closing on their replacement property. This can create a constructive receipt problem because the exchanger would be either controlling or holding the exchange funds. The IRS would likely rule that the funds aren't being used to purchase real estate, causing the exchange to fail. As a result, the taxpayer would have to report both the sale and purchase of the real estate separately, instead of as a 1031 exchange transaction.
Consult with your tax advisor, as increasing the mortgage debt on the replacement property due to a higher purchase value might offset the non-allowable closing costs and reduce your tax liability.
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