Closing costs are a popular topic when it comes to the sale or purchase of any property, and your 1031 exchange certainly requires a close look at how these costs are allocated. Generally, a properly structured 1031 exchange requires that the Exchanger use the sale proceeds from the Relinquished Property (the “exchange funds”) to purchase Replacement Property.
Exchange funds can also be used to pay closing costs on the sale and purchase of exchanged properties without disqualifying the 1031 exchange. Treas. Reg. §1.1031(k)-1(g)(6). To fall under this “safe harbor” protection, the closing cost must relate to the sale or purchase of an exchanged property and customarily appear on settlement statements as paid for by the buyer or seller. Treas. Reg. §1.1031(k)-1(g)(7). Common examples of permitted closing costs (also called “exchange expenses”) include:
real estate broker fees (see Revenue Ruling 72-456)
transfer taxes, recording fees, and title company fees
closing attorney fees
qualified intermediary fees
costs of surveys, environmental inspections, or other inspections
down payment on the Replacement Property
Paying these exchange expenses out of the exchange funds does not prevent them from reducing the realized gain on the Relinquished Property or increasing the tax basis in the Replacement Property. PLR 8328011. In other words, when the Exchanger pays these exchange expenses, it can reduce the amount the Exchanger has to spend for the Replacement Property.
However, the use of exchange funds to pay some closing costs may result in taxable “boot.” The following is a list of closing costs that may be treated as boot if paid for using exchange proceeds:
pre-paid rents and security deposits tenants
loan acquisition fees (e.g., origination charges, appraisal fees, mortgage insurance)
credits to buyer for property repairs
BEWARE: An Exchanger's use of the exchange funds for certain expenses unrelated to the sale or purchase of exchanged properties may disqualify the 1031 exchange altogether. This pitfall happens when the Exchanger is deemed to be in “actual or constructive receipt” of the exchange proceeds before the exchange is completed or otherwise properly terminated. Treas. Reg. §1.103(k)-1(g)(6).