top of page

Allowable and Unallowable 1031 Exchange Closing Costs



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.

Comments


bottom of page