FEATURE ARTICLE, MARCH 2007

TREATMENT OF CLOSING COSTS IN A 1031 EXCHANGE
Pamela Michaels

Not a day goes by when an investor, attorney, CPA or other real estate professional does not ask me “What costs may I pay out of the sale proceeds without incurring tax?” Many mistakenly assume that all closing costs may be deducted and paid from the proceeds upon the sale of the relinquished property without tax consequences. Not so.

IRC §1031 permits investors to deduct exchange expenses from sale proceeds. However, exchange expenses do not include all closing costs and are not the same as closing costs. Exchange expenses are defined as those expenses typically incurred in connection with the purchase and sale of real estate. Thus, certain costs are generally considered to be exchange expenses. Such costs generally include:

A. A direct cost of selling real property, such as real estate commissions; the cost of the owner’s title insurance premium incurred in connection with the acquisition of the replacement property; closing or escrow fees; legal fees; transfer taxes; notary fees; recording fees and broker’s commissions (Revenue Ruling 72-456); or

B. Costs specifically related to the fact the transaction is an exchange such as the Qualified Intermediary fees.

Note that exchange expense include both any such fees incurred in connection with the sale of the relinquished property as well as any such costs incurred in connection with the purchase of the replacement property. Thus, to determine the minimum actual dollar amount that an investor must spend on the replacement property to achieve 100 percent deferral, one must subtract from the sales proceeds, the total amount of the investor’s exchange expenses incurred on both sides of the exchange.

But note that some expenses, while often incurred in connection with the purchase and sale of real estate are not necessarily considered exchange expenses. Loan-related fees incurred in connection with financing obtained to purchase the replacment property are an example of the type of fees that fall into a category where there is no clear guidance. These fess would include points, appraisals, environmental reports, credit reports, mortgage tax and the cost of the mortgagee’s premium for the lender’s title insurance policy. One perspective, the more conservation approach, is that investors may always buy for all cash, and that, thus, loan-related fees are not exchange expenses. The other more liberal view is that most investors provide a financing contingency in their purchase contracts and that, therefore, such expenses should be considered a necessary condition of the purchase and thus deductible from the sale proceeds.

Other items, while considered closing costs, are not considered exchange expenses and if paid from sale proceeds will likely result in taxable boot in the event of audit.  Such items are items which are incurred as a result of the ownership of the property and not its sale. Adjustments and prorations fall into this category. Thus, ad valorem taxes; mechanic’s liens; payments to render title to a property marketable; credits for prepaid rent and security deposits; and utility charges are not considered exchange expenses, though they are closing costs. If an investor desires to ensure a 100 percent deferred exchange, he or she should consult with his/her legal or tax advisor and, with their guidance, consider bringing separate funds to closing to pay for any adjustments, prorations or fees which fall into this category, rather than pay them from sales proceeds.

In today’s marketplace, investors are incurring defeasance fees on an increasing basis in connection with the prepayment of mortgage debt due to the fact that many investors obtained securitized loans. These  fees cannot likely be considered exchange expenses as they are paid to compensate the lender for a shortfall in interest payments when the loan is paid off prior to maturity. However, an investor may be able to argue that these fees are part of the mortgage debt and thus declare no boot when a part of the sales proceeds is used to pay such fees, presuming the investor replaces the debt, including the defeasance fee portion, on purchase of replacement property or makes up any shortfall by putting in cash from another source. There is some authority for this if the result is that the investor is fully discharged from the debt upon payment. If shortfall liability is retained, then the fee is generally considered not to be interest in nature and not part of the mortgage debt. However, as there is no definitive authority on the issue, investors should proceed with caution and consult with legal and tax advisors before proceeding.

Note also that whether a payment is an exchange expense or not does not determine whether or not it is capitalized for the purpose of adjusting the basis of the relinquished or replacement property. A determination that an item is an exchange expense simply means that sales proceeds can be used to pay the expense without jeopardizing 100 percent tax deferral. For instance, a broker’s commission is considered an exchange expense for 1031 exchange purposes. But for determining one’s basis in the property sold or purchased, it is added to the basis and thus reduces future capital gain by such amount.

The rulings on the issues described above are evolving. Thus, as with any tax matter, legal and tax advice should be solicited before proceeding.

Pamela Michaels is northeast division manager of Asset Preservation in New York.


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