One reason why real estate can be an attractive investment opportunity is because of the potential deductions involved with owning and maintaining income-generating properties (or those used for business purposes). When it comes time to sell that property, certain closing costs can be deducted (including mortgage interest and pro-rated property taxes).
The situation is a little different for investors using a 1031 exchange to dispose of their relinquished property and acquire a replacement property of equal or greater value. In this case, there are closing costs that can be considered “qualified exchange expenses.” These can be deducted against the investor’s realized or recognized gain, while also potentially reducing the replacement property’s tax basis.
However, not all expenses involved with the like-kind exchange are deductible. The chart below lists some of the more common qualified exchange expenses (which can be used as deductions) and non-qualified exchange expenses (which cannot be used for this purpose).
|
Qualified Exchange Expenses (Can be Deducted) |
Non-Qualified Exchange Expenses (Cannot be Deducted) |
|
Broker/agent commission |
Loan costs |
|
Exchange fees |
Property taxes |
|
Qualified intermediary fees |
Title insurance fees (lender’s title insurance policy) |
|
Recording fees and transfer taxes |
Lender-mandated appraisals and environmental studies |
|
Escrow fees |
Security deposits |
|
Appraisal costs (as required by the contract) |
Pro-rated rent |
|
Attorney or CPA fees connected to the exchange |
Insurance premiums |
There are times during which investors might use exchange funds to pay for some of the non-qualified expenses listed above. Doing so doesn’t necessarily disqualify the exchange. But it can generate boot. And that boot, in turn, could trigger a partial capital gains/depreciation recapture tax.
Furthermore, some of the above-mentioned non-qualified exchange expenses could be used as income tax deductions. For example, property taxes can’t be used to reduce a replacement property’s basis. But they could be useful when it comes time to filing federal and state income taxes.
To summarize, some closing costs can be deducted as part of a 1031 exchange, while others are non-qualified expenses. To be sure that the right costs are being deducted for the right purposes, be sure to follow the instructions of a qualified tax advisor.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
