When doing a 1031 exchange, the tax benefits can be substantial, but there are fees and costs to consider.
A 1031 exchange is the deferment of capital gains taxes when an investment property is relinquished and replaced with a like-kind property. This allows a taxpayer to use the funds to purchase a new investment while shifting the tax liability.
The costs involved in a 1031 exchange include fees paid to a Qualified Intermediary (QI) and the costs of doing a real estate transaction(s).
Qualified Intermediary Fees
One of the major costs in a 1031 exchange is the payment to the Qualified Intermediary. A QI is a third party that facilitates the transfer process between the relinquished and replacement properties. They are the titleholder during the exchange process and also have control of the escrow account.
Fees for a QI vary, but generally range from $500 to $1,500. Some charge per exchange, but others might charge separate fees for the relinquished property and the new property. Additional fees would apply if there are multiple properties involved in either side of the transaction.
A QI might also charge more if it is a complex transaction.
The fee may seem small for the responsibilities an intermediary holds, but depending on the terms of the contract, they may sometimes keep the interest on the money kept in escrow. Depending on the amount, this can add up quickly.
It is also important to remember that you get what you pay for. Choosing a QI just because they have the lowest fees could present challenges that could end up being more costly to the taxpayer in the long run.
Standard Fees of Real Estate Transactions
A 1031 exchange will include at least two, and maybe more, real estate transactions. If there is a QI involved, they pay the expenses for the sale and purchase of the properties from the proceeds of the exchange that are kept in an escrow account set up by the taxpayer.
However, some of these fees are considered taxable, called non-exchange expenses, while some are not taxable, called exchange expenses. Exchange expenses are the costs of directly buying or selling a property, or the cost of acquisition. Non-exchange expenses are operating expenses or loan fees.
Examples of exchange expenses:
- Transfer taxes
- Qualified Intermediary fees
- Owner’s title insurance premiums
- Recording fees
- Escrow fees
- Finder's fees
- Inspection fees
- Real estate commissions
- Legal fees
Examples of non-exchange expenses:
- Mortgage insurance
- Repairs or maintenance
- Homeowners association fees
- Lender’s title insurance premiums
Also consider that anything paid for out of the exchange funds that is considered a cost of obtaining a new loan is a non-exchange cost, and subject to tax liability. The direct costs of acquiring the property, however, does not generate a taxable event.
Another way to look at it is to think of the transaction as an all-cash transaction. Anything that would not be included in an all-cash scenario, including loan acquisition fees, are subject to taxes if paid with the proceeds from the exchange.
The 1031 Investor's Guidebook
Tackle the art and science of completing your 1031 exchange.