Closing Costs in a 1031 Exchange - a Trap for the Unwary?
Closing statements are replete with prorations and credits that adjust the sales price. Other line items reflect the payment of recording fees, title insurance and other transaction expenses. Seemingly routine, the way these expenses are handled in a §1031 exchange may have unintended tax consequences.
Remember that the rationale for tax-deferral under §1031 is that the taxpayer has merely moved his investment from one property to another. The form may have changed, but as long as the underlying investment remains unchanged no tax is due. Any “cashing out” of the investment (i.e. reduction in equity) will be taxed.
In some instances, using exchange funds to pay closing costs or issue credits that adjust the price, may be a form of cashing out. The result is that the transaction may be partially taxable.
Another concern is that paying certain expenses could be construed as impermissible receipt of the exchange funds. Under the IRS regulations the taxpayer cannot have actual or constructive receipt of the exchange funds. Improper receipt could cause the entire exchange to fail.
The IRS and case law provide very little guidance on this topic. This article discusses the issues in general, but because of their uncertainties and technical nature, it is important that every taxpayer have his tax advisor approve each closing statement, so there are no surprises when preparing the tax return.
Exchange Expenses
Certain items paid at a closing are considered “Exchange Expenses”. Using exchange funds to pay those expenses will not result in a tax liability to an investor doing a §1031 exchange. For example, Revenue Ruling 72-456 provides that if exchange funds are used to pay brokerage commissions, it does not result in the transaction being partially taxable. There are no other clear rulings on this subject, but most tax advisors agree that the following expenses are exchange expenses and may be paid at the closing of the relinquished or replacement properties without any tax consequence:
- Brokerage commissions
- Exchange fees
- Title insurance fees for the owner’s policy of title insurance
- Escrow fees
- Appraisal fees required by the purchase contract
- Transfer taxes
- Recording fees
- Attorney’s fees incurred in connection with the sale or purchase of the property
Non-Exchange Expenses
Not all expenses are Exchange Expenses. Exchange funds can be used to pay a non-exchange expense, although doing so may result in the exchange being partially taxable. Such payments will not invalidate the application of the Qualified Intermediary safe harbor, but they may still constitute boot to the Exchanger. On a typical settlement statement the seller of the relinquished property will give the buyer a credit against the sales price, representing security deposits and prorated rents. Effectively, the seller was using exchange funds to pay the security deposit and prorated rent amounts to the buyer. To avoid a taxable event, the seller should deposit his own funds to pay those security deposits and prorated rents to the buyer, rather than giving a credit.
In addition, most tax advisors believe that fees and costs paid in connection with getting a loan to acquire the replacement property should be considered costs of obtaining the loan, not costs of acquiring the replacement property, and thus are not Exchange Expenses. To avoid any potential tax liability, the buyer may want to deposit his own funds to pay loan related expenses.
Some non-exchange expenses create a tax liability but are offset by a deduction. One example of this is property taxes. Although property taxes are not an Exchange Expense, the investor will get a deduction for paying the property taxes, and that liability will be offset by a deduction.
The following items are typically found on a closing statement but are generally not considered Exchange Expenses because they do not relate directly to the disposition of the relinquished property or the acquisition of the replacement property:
- Loan costs and fees
- Title insurance fees for the lender’s title insurance policy
- Appraisal and environmental investigation costs that are required by the lender
- Security deposits
- Prorated rents
- Insurance premiums
- Property taxes
Transactional Items and Constructive Receipt
A separate, but important, issue is whether paying a non-exchange expense from exchange funds will be construed as constructive receipt of those funds by the investor, which has the potential to disqualify the entire exchange. Under the IRS Regulations exchange funds can be used to pay “transactional items that relate to the disposition of the relinquished property or to the acquisition of the replacement property and appear under local standards in the typical closing statement as the responsibility of a buyer or seller (e.g., commissions, prorated taxes, recording or transfer taxes, and title company fees).”
For example, an investor may want to use exchange funds to pay a rate lock-in fee to a lender. Since these fees by their nature are paid before the closing, and are not strictly required for the acquisition of the replacement property, paying the fee from exchange funds may trigger a constructive receipt problem.
Since there is no clear IRS guidance, it is important that investors discuss the issue with their tax advisors before seeking to use exchange funds to pay non-exchange expenses, whether prior to, or at the replacement property closing.
References
Revenue Ruling 72-456; TAM 8328011; Treasury Regulation §§ 1.1031(k)-1(g)(6) and (7); IRS Form 8824.