What are Allowable 1031 Exchange Expenses?

Closing costs on commercial real estate can be extremely high, sometimes averaging between 3 and 5 percent of the total value of the asset you are buying. If your target property costs $2 million, that 3 percent could exceed $60,000 in fees and related expenses. 

Investors who are undertaking 1031 exchanges often want to know what fees and closing costs are permissible, as well as whether or not they can use proceeds from the sale of their relinquished assets to cover certain routine transaction fees expenses. Let’s look at which expenses are allowed in a 1031 exchange, and how to best cover them. 

1031 Exchange Permissible Expenses 

Fees paid to specialists or agents who facilitate your 1031 exchange real estate transaction that are permissible may include: 

• Finder’s/referral fees and broker commissions 
• Escrow or settlement agent fees 
• Attorney’s fees, both at the closing table and for any expenses incurred during disposition or acquisition 
• Payments made to your tax advisor for providing situational guidance on the exchange 
• Fees paid to your Qualified Intermediary (QI) or exchange facilitator 

There are a few special considerations regarding the fees you pay to your QI. Any fees that are destined for your exchange facilitator must be established prior to the disposition of the relinquished asset, and those fees are your responsibility to pay regardless of whether there are sufficient exchange funds to cover the amount.¹  

Common permissible real estate closing costs that may be incurred during the sale of your relinquished asset and purchase of a replacement property can include: 

• Title search fees 
• Title insurance premiums for the owner 
• Transfer taxes 
• Recording and filing fees 

These exchange expenses are reported on IRS Form 8824 Like-Kind Exchanges, and can be aggregated and deducted from the contractual price of the replacement asset, thereby lowering the total amount of your realized gain. 

1031 Exchange Non-Permissible Expenses 

Following is a list of common real estate expenses that aren’t permissible.  

• Security deposits 
• Repair and maintenance costs 
• Insurance premiums 
• Prorated rents and property taxes 
• HOA or association dues 
• Inspections and appraisals 
• Mortgage or lender title insurance 
• Loan processing fees 

Loan fees are not permissible because they are considered integral to obtaining rather than acquiring your replacement asset. An alternative to potentially generating a taxable event is to add cash to closing to cover any non-permissible expenses. 

Non-permissible exchange expenses that are paid by your Qualified Intermediary using 1031 exchange sale proceeds will likely result in taxable boot – or even a failed exchange. However, certain expenses, such as accrued interest, security deposits received, or prorated payments on property taxes can be treated as non-recourse debt and be used to offset debt incurred on the replacement property (provided it’s larger than the mortgage on the relinquished asset). 

Closing Thoughts 

The waters can be a bit murky when it comes to paying transactional and other 1031 exchange expenses using sale proceeds from your relinquished asset. Similarly, exchangors must be extremely cautious about receiving security deposits and rents already paid by tenants to the seller. If these funds go to the buyer rather than the qualified intermediary, it will be considered taxable boot. You can avoid this situation by having the seller deposit any prepaid rent or security deposits into an escrow account prior to closing. 

A prudent course of action would be to engage legal, taxation and financial professionals to discuss your particular 1031 exchange situation prior to sitting down at the closing table. Their insight can help ensure you pay for each permissible expense correctly, whether it's from exchange sale proceeds or from your personal funds. 

^{1§ 1.468B-6 - Escrow accounts, trusts, and other funds used during deferred exchanges of like-kind property under section 1031(a)(3), e laws.us, http://federal.elaws.us/cfr/title26.part1.section1.468b-6}