Selling and buying a home is full of fees, expenses, and individual line items that can confuse the process and generate much of the closing paperwork. When selling or purchasing an investment property in a 1031 exchange process, certain selling expenses paid out of the sales or 1031 exchange proceeds will result in a taxable event for the exchanger.
The IRS is very clear about many of these costs of selling a property, for example, routine selling expenses such as broker commissions or title closing fees will not create a tax liability. Inversely most operating expenses paid at closing from 1031 proceeds will create a tax liability for the exchanger.
The IRS, over time and in several notes, instructions and guidelines has made the following clear:
Allowable closing expenses for IRS 1031 exchange purposes are:
- Real estate broker’s commissions, finder or referral fees
- Owner’s title insurance premiums
- Closing agent fees (title, escrow, or attorney closing fees)
- Attorney or tax advisor fees related to the sale or the purchase of the property
- Recording and filing fees, documentary or transfer tax fees
Closing expenses that result in a taxable event are:
- Pro-rated rents
- Security deposits
- Utility payments
- Property taxes and insurance
- Associations dues
- Repairs and maintenance costs
- Insurance premiums
- Loan acquisition fees: points, appraisals, mortgage insurance, lenders title insurance, inspections, and other loan processing fees and costs
To reduce the taxable consequences of these operating, financing, and other closing fees, try to:
- Pay security deposits, pro-rated rents, and any repair or maintenance costs outside of closing, or deposit these amounts in escrow with the closing agent.
- Treat accrued interest, prorated property tax payments, or security deposits as non-recourse debt that the exchanger is relieved of on the sale of their old property, which could be offset against the debt assumed on the replacement property. Note: this would only work if mortgage debt is obtained on the replacement property purchase that exceeds the mortgage debt paid off on the sale of the relinquished property.
- Match any prepaid taxes or association dues credited to the investor against the unallowable closing expenses listed on the settlement statement.
Check with your tax advisor prior to the closing to review the closing settlement statements to determine if there is an opportunity to avoid a taxable transaction in your 1031 exchange. It’s possible that an exchanger has a long-term loss carry forward or non-recognized passive operating losses that could offset the taxable amount.
Please note that all material provided in this newsletter is for informational purposes only and the author is not providing legal, tax accounting, or other professional services. The accuracy of the information provided as it pertains to your situation is not guaranteed. Please seek professional consultation if legal, tax accounting, or other expert assistance is required.