Real estate investors can employ a 1031 exchange to sell an investment property and reinvest the proceeds into a “like-kind” replacement without paying capital gains taxes, depreciation recapture taxes, or NIIT (Net Income Investment Tax). This tool may offer a significant advantage in circumstances where an asset has appreciated significantly. However, there are costs associated with the exchange transaction. These costs vary depending on the specific nature of the 1031 exchange.
Use of a Qualified Intermediary
A Qualified Intermediary is a neutral third party that the investor must engage to facilitate the 1031 exchange transaction. It is crucial that a QI manage the sale and purchase of the relinquished and replacement properties, to ensure that the taxpayer remains at arms-length from access to the funds or eligibility for the tax deferral is at risk. The duties of the QI include:
- Holding the proceeds from the sale of the relinquished property.
- Receiving and holding the formally identified potential replacement properties before the end of the 45 days.
- Managing the purchase of replacements within the 180 days allotted and keeping accurate transaction records.
For their services, the Qualified Intermediary (whether a person or a company) will charge a fee, which may range from $500 to $1500 or more, depending on the complexity of the transaction. However, suppose the QI fee structure entitles them to keep the interest accrued on the funds they hold between the initial sale and the purchase of replacement assets. In that case, that may allow the investor to pay a lower service amount.
What Are Other Fees Involved in a 1031 Exchange?
Since real estate sales and purchases always involve fees, investors can expect to pay the same items when completing a 1031 exchange. These costs include:
- Transfer taxes
- Title Insurance
- Recording charges
- Escrow costs
- Inspection costs
- Real estate commissions
- Legal charges
- Appraisal service fees
What About Broker Fees?
In a standard exchange of one real estate asset for another, you may not pay a broker fee, although you might add a finder’s fee to the above real estate-related costs. However, if you are contemplating a 1031 exchange involving entry into or exit out of a Delaware Statutory Trust, you may need to plan for the expense of a broker commission. This is because registered representatives and investment advisers sell most DST investments.
When considering a DST as a 1031 exchange investment, taxpayers may consider the fees a potential downside, but there are pros as well.
- Since DSTs are customizable, investors may be able to precisely purchase the amount of replacement property they want, thus ensuring that they fully cover the proceeds from the relinquished asset without needing to commit additional capital.
- DSTs are professionally managed, passive investments that can either be directed to a specific sector and class or deliberately range across various categories, including multi-family housing, industrial property, retail and hospitality, self-storage, and other commercial real estate.
- The ready nature of a DST investment reduces the risk inherent in a 1031 exchange. The investor does not have as much exposure as with a property purchase, which can be delayed for various reasons.
Is There a Fee to Exit a DST?
Investors should consider DST assets to be illiquid since most have holding periods of five to ten years. There may be options for early exits, depending on the circumstances, but these will typically come with costs and should be evaluated with the assistance of a financial and tax advisor.
