Counseling Clients on Closing Costs in a 1031 Exchange
Accountants can contribute a lot of value to clients by providing them with some level of counsel on allowable closing costs in a 1031 exchange.
Given that a 1031 exchange necessarily involves the sale of real estate, closing costs will always be a part of the transaction.
Clients routinely ask which of these costs can be paid directly with exchange proceeds without producing a taxable event. In this post, we will discuss the issue of allowable and nonallowable closing costs in an exchange.
It’s important to note that closing costs can only be fully resolved on an individualized basis. There is widespread agreement as to the classification of most closing costs, but this doesn’t mean that the IRS couldn’t still challenge the allowability of a closing cost in a given situation.
The Regulations Leave Room for Interpretation
The Section (k) Treasury Regulations refer specifically to closing costs in 1.1031(k)-(1)(g)(7). In that paragraph, the regulations refer to “items” received in the disposition of property, and transactional costs which “relate” to the disposition of the relinquished property or acquisition of the replacement property.
The language used in this paragraph is ambiguous and leaves room for interpretation as to whether a given cost relates to the disposition or acquisition. However, the regulations do list specific examples (i.e. transfer taxes, agent commissions, prorated taxes, recording fees, title company fees, etc.).
Allowable vs. Nonallowable Closing Costs
Intermediaries, attorneys and other 1031 specialists have a rough idea of the costs which will be classified as allowable in an exchange. Conversely, they also have a rough sense of which costs are regarded as nonallowable. Here are some of the allowable costs:
· Escrow fees
· Title insurance fees
· Real estate broker’s commissions
· Appraisal costs (for purchase contract exclusively)
· Attorney’s fees related to the sale
· Recording fees
· Excise or transfer taxes
· Prorated taxes
· Qualified intermediary fees
Here are some of the nonallowable costs:
· Costs related to financing
· Prorated rents
· Security deposits
· Property taxes
· Insurance premiums
· Appraisals required by a mortgage lender
· Environmental checks required by a lender
· Other mortgage related costs (application fees, points, etc.)
· Non-transactional costs (utility bills, credit card bills, etc.)
Neither of these lists is exhaustive and different exchanges will have different costs. Certain mortgage loan lenders, for instance, will have different requirements built in to their lending process. But, you can give clients a general idea of what’s happening by referencing these lists.
The purpose behind these lists is to provide fairness to the taxpayer conducting the exchange. We all understand that there is a wide range of expenses which must naturally be incurred whenever real estate is either sold or purchased.
The fair solution to this issue is to allow taxpayers to offset their gain when they use exchange proceeds to pay off costs which follow normally in the course of business. A taxpayer shouldn’t suffer a financial penalty, for instance, for using exchange funds to pay off a broker’s commission; that is a normal aspect of business.
Allowable Costs Offset Gross Sales Proceeds
The key benefit of allowable costs is that these costs offset the gain realized from the underlying sale in the 1031 exchange. This is the point which accountants need to drill home for their clients. Suppose your client sells a property for $1 million, and has allowable closing costs of $100,000.
In this scenario, the taxpayer would be treated as though the property itself was sold for $900,000, rather than $1 million. The taxpayer wouldn’t be required to obtain a replacement property of at least $1 million in order to achieve full tax deferment. The closing costs effectively offset the gain realized on the sale. From a tax standpoint, it is as though the relinquished property sold for $900,000.
Nonallowable Costs Produce Taxable Consequences
The downside to nonallowable closing costs is that they produce taxable consequences when paid with exchange proceeds. If, in the above scenario, the taxpayer also had nonallowable closing costs of $50,000, the taxpayer would need to bring in outside funds to cover those costs.
If the taxpayer used exchange proceeds to pay them off, this would produce a taxable event. The taxpayer would be treated as having received boot of $50,000 and would have to pay taxes on that $50,000 (or to the extent of the gain). Logically, this makes sense.
Using exchange funds to cover nonallowable costs is the same as using those funds to make independent, non-exchange related purchases. Exchange proceeds are designed to go specifically toward the acquisition of more investment real estate; that is the purpose of Sec. 1031. Using exchange funds to pay off things which have no clear of sufficient relation to the exchange goes against the purpose of the code.
Bottom line: If your client identifies that he or she will indeed have nonallowable costs in his or her exchange, counsel that client to either bring in additional funds from outside the exchange, or be prepared for the tax hit. Depending on his or her overall tax situation, one strategy may be better than another.
Jorgen Rex Olson is a graduate of Washington State (B.A., cum laude, 2008) and the Indiana University (McKinney) School of Law (J.D., 2012). He writes for Mackay, Caswell & Callahan, P.C., one of the leading tax law firms in New York State.