Permissible and Non-Permissible 1031 Exchange Closing/Settlement Costs
1031 exchange proceeds can be used to pay for certain routine permissible transaction, settlement and closing costs related to the disposition of the relinquished property and/or the acquisition of the replacement property without creating an income tax liability ("boot") for the investor.
Other expenses, financing costs and settlement charges can be paid from the 1031 exchange proceeds, but will be considered cash boot received to the investor and may therefore result in an income tax liability (non-permissible 1031 exchange settlement expenses and closing costs). In certain situations, cash boot paid can be offset by cash boot received and will reduce the investor's income tax liability.
Investors should therefore always review their estimated settlement statement and/or HUD-1 statement with their tax and/or legal advisors prior to approving the estimated settlement expenses and closing costs to ensure they have a complete understanding of the income tax consequences from the transaction prior to the closing of the transaction.
The more common permissible and non-permissible 1031 exchange expenses and closing costs are listed below. Permissible and non-permissible 1031 exchange expenses and closing costs can vary by geographic region based on common practices, local standards and customs.
Permissible Expenses and Closing Costs:
- Owner's title insurance premiums
- Escrow or settlement agent Fees
- Real estate broker's commissions
- Finder fees or referral fees
- 1031 exchange Qualified Intermediary Fees
- Documentary transfer taxes
- Recording or filing fees
- Attorney fees and costs related to the acquisition
- Tax advisor fees related to the acquisition
Non-Permissible Expenses and Closing Costs:
- Financing activities such as loan fees, loan points, appraisal fees, mortgage insurance premiums, lender's title insurance policy premiums, and other loan processing fees and costs
- Property taxes
- Prorated rents
- Insurance premium payments
- Security deposits
- Payoff of credit card balances
- Repairs and/or maintenance costs
Further, financing costs and other costs not related to the direct acquisition of the replacement property(ies) can only be paid at the close of the replacement property(ies) when the Qualified Intermediary (Accommodator) disburses all of the 1031 exchange funds it is holding to the closing agent.
Non-exchange expenses debited to the investor and paid with 1031 exchange funds are taxable boot, but this boot may be offset (by other items, such as prepaid taxes or dues credited to the investor).
Accrued interest, prorated property tax payments, or security deposits paid to the buyer of the relinquished property can be treated by the investor as non-recourse debt from which the investor is relieved of and can be offset against debt assumed on the replacement property.
The investor should always consult with his legal, tax and financial advisor prior to closing on each property and completing the tax-deferred like-kind exchange transaction so these items can be addressed before it is too late. Advisors may recommend that investors pay for certain costs at the close of the transaction with personal funds in order to avoid creating taxable boot.
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