Allowable and Unallowable 1031 Exchange Closing Costs

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There are always issues with closing costs associated with 1031 exchanges. All exchangers want to have their closing costs paid with 1031 proceeds without creating a taxable event. Some closing costs paid by exchange proceeds are allowable by the I.R.S., while others are taxable. The I.R.S. Revenue Ruling 72-456 specifies, for example, that if exchange funds are used to pay a broker’s commissions, it does not ruin a 1031 exchange. 

Here’s a list of specific exchange expenses that are allowed by most tax advisors:

  • Title insurance fees
  • Escrow, title company or attorney’s 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 for purchase contract
  • Tax advisor fees related to the sale or acquisition of property
  • and, as mentioned above, Broker commissions

Other common closing costs that are NOT exchange expenses can result in tax liability if they are paid with 1031 proceeds. For example, security deposits and prorated rents for the sale of exchange property that are paid with 1031 proceeds WILL create a taxable event. To avoid this, have the security deposits and pro-rated rents paid outside of closing, or funded directly by the seller at closing. 

Common NON-allowable closing costs which are listed on a settlement statement include:

  • Costs related to financing:
    • loan costs,
    • application fees,
    • points, and
    • other lending fees 
  • Title insurance fees for 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, etc.
  • and, also mentioned above: Security deposits, and 
  • Prorated rents

To avoid a tax liability, a buyer could deposit their own funds to pay any loan-related expenses. In addition, some of the unallowable expenses that create a tax liability are offset by a tax deduction. Property taxes, insurance premiums, utility bills are all deductible rental expenses. 

Another issue occurs when an exchanger requests to have loan lock in fees or loan and application fees paid out of exchange proceeds prior to the closing of their replacement property. This would create a constructive receipt problem as the exchanger would be either controlling or actually holding the exchange funds. The I.R.S. would rule that exchange funds are not being utilized to purchase real estate. Consequently, the I.R.S. would most likely fail the exchange, since the taxpayer received the 1031 proceeds. The taxpayer would then need to report both the sale and the purchase of the real estate instead of a 1031 exchange transaction.

Check with your tax advisor as increased mortgage debt on the replacement property purchase due to buying up in value may offset the unallowable closing costs and reduce tax liability.

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