One of the most frequently asked questions from clients planning a 1031 Exchange is, “Can I use my exchange funds to pay for closing costs without being taxed”? Although surprisingly little guidance is available in the tax code, there are some rules of thumb that will help clients and their tax advisors determine how best to structure a 1031 Exchange without paying unnecessary capital gains taxes.
Closing costs, for purposes of this article, are defined as all costs associated with the closing of a property that is required to complete the transaction. Such costs are required to be disclosed to all sellers and buyers of real property in the HUD-1 Closing Statement. Any cost that is incurred outside of escrow or the closing process generally should not be paid for using 1031 Exchange funds, unless the exchange client is willing to pay tax on the amount spent. Such pre-closing items include all maintenance and fixer costs that are incurred to prepare the property for sale. In addition, exchange clients should not be reimbursed for such costs in escrow without being taxed. It is best to pay for such pre-closing costs “out of pocket”.
For costs that are part of the escrow or closing, you must separate each item into two basic categories.
First are costs that are non-recurring and specifically related to the closing. Such costs can generally be paid for using exchange proceeds and will reduce the property’s net sales price for sellers or increase the net purchase price for buyers. A non-inclusive list of such costs includes:
* Sales commissions
* Title and escrow fees
* Recording fees
* Transfer Taxes
* 1031 Exchange Intermediary fees
The second category of items include the costs that are either recurring or do not specifically relate to the closing. Such costs should not be paid for using exchange proceeds without incurring a tax liability. When selling property, such costs should be paid for “out of pocket”. When buying property, such costs should either be paid for with loan proceeds, if possible, or “out of pocket”. These costs also do not decrease the net sales price or increase the net purchase price. A non-inclusive list of such costs includes:
* Mortgage interest
* Mortgage prepayment penalties
* All prorated expenses including property taxes, utilities, homeowner’s fees and insurance expenses.
Seller and Buyer Credits
One other item that frequently shows up on closing statements and the list of most frequently asked questions involves seller and buyer credits. Such items do not require a payment, the way an invoiced cost would. When a seller is given a credit by a buyer, it will increase the net purchase price. When a buyer is given a credit by a seller, it will decrease the net sales price. It does not matter what the credit is for. For instance, if a seller credits the buyer for “closing costs”, that credit will reduce the net sales price, as if the seller had paid the closing costs themselves.
This situation is frequently encountered with buyers who are attempting to acquire replacement property as part of their 1031 Exchange. Let’s say that the buyers need to purchase property for $500,000 to complete their exchange, but really like a property that is worth $475,000. If the buyer acquires the property for $475,000 and completes their exchange, they will have $25,000 in exchange boot that will be subject to tax. To try and avoid paying taxes, the buyer offers $500,000 for the property, but asks for a $25,000 buyer credit. Unfortunately, such a credit reduces the net purchase price and the buyer will still have a $25,000 boot and resulting tax liability.
As mentioned in the introduction, there is relatively little guidance in the tax code when it comes to the deductibility of costs associated with real estate closings. A taxpayer involved in an exchange should always discuss the issue of closing costs with their taxpayer. Hopefully, this article has provided some rules of thumb that will make taxpayers more knowledgeable when discussing the matter and planning their exchange with tax counsel.
Leonard Spoto at Asset Exchange can answer all your questions.