When selling or purchasing an investment property in a 1031 exchange, certain expenses paid from 1031 proceeds will result in a taxable event for the investor. Routine selling expenses do not create taxable boot. Operating expenses and financing fees paid out of sales proceeds will result in taxable boot. A close examination of the closing statements for both properties (relinquished and acquired) can reveal what might be considered boot. In this article, we’ll navigate the taxability of selling expenses in a 1031 exchange.
Common/Routine Closing Costs
Many closing costs are one-time costs, also known as transactional expenses. They relate to the disposition of the relinquished property or acquisition of the replacement property. Below is a list of transactional expenses that do not generate a taxable event:
- Broker commissions
- Tax advisor expenses
- Owner’s title insurance premiums
- Qualified intermediary fees
- Environmental inspections related to the exchanged properties
- Recording or filing fees
- Attorney fees associated with the disposition
- Escrow agent and settlement agent
As an example, when you pay broker commissions on the relinquished property, you reduce the gain and offset the boot. The result is a reduction in taxes.
You’ll notice that loan acquisition costs are not listed. Loan fees paid from exchange proceeds result in taxable boot since they are a benefit unrelated to acquiring the replacement property. They are considered the cost of obtaining a new loan rather than a direct cost of acquiring the replacement property. One way to test whether or not an expense creates a taxable boot is to look at the transaction as an all-cash transaction. Loan fees, of course, will not be included in that scenario. Loan fees include points, appraisal fees, lender’s title insurance, and assumption fees. To avoid creating a taxable event, exchange proceeds should not be used to cover loan acquisition fees.
Common Operating Costs
Operating costs are not part of the direct cost related to acquiring the replacement property. These are costs that are considered outside of the exchange. Operating costs can create taxable boot or even be considered receipt of exchange funds, the latter being a condition you’d rather avoid since it is a violation of the Treasury 1031 rules.
Operating costs include prorated property taxes, prorated rents, security deposits, and maintenance costs.
In some cases, the exchanger may be asked to provide a credit to the buyer of the relinquished property. This credit can help offset closing costs and repairs. The credit comes from the sale proceeds, which reduces the sale price. For the exchanger, no taxable event is created.
Operating costs and financing fees can be a vague area. It’s always best to discuss various closing costs with your tax advisor.
By working with your tax advisor and being aware of various closing costs, whether they show up on your statement or not, you can identify taxable vs. non-taxable expenses. Knowing which types of expenses you’re dealing with can lead to a more efficiently taxed 1031 exchange experience.