Exchange Expenses

Exchange expenses will reduce both realized and recognized gain, as well as increase the basis of the replacement property. The IRS applies a two-part test to determine exchange expenses.

1. The expense must relate to the disposition of the relinquished property or the acquisition of the replacement property, and
2. Appear under local standards on the typical closing statement as the responsibility of a buyer or seller. Reg. 1.1031(k)-1(g)(7)(ii).

Exchange expenses are not specifically identified by the IRS, but should include the following:

• Expenses that would be deducted from the gross proceeds in a taxable sale;
• Expenses that are nondeductible by a buyer in a taxable sale, but added to the basis of the property acquired; or
• Expenses directly related to the fact that the transaction is an exchange.

Examples of exchange expenses include the following:

• Intermediary fees
• Real estate commissions
• Title insurance premiums
• Escrow fees
• Legal fees related to the specific exchange transaction
• Transfer taxes
• Recording fees

Non-exchange Expenses do not affect realized gain, recognized gain, or replacement property basis. They include the following:

• Mortgage interest
• Loan fees and costs
• Security deposits
• Prepaid rent
• Prorations such real estate taxes, association fees, etc.

Non-exchange expenses debited to the seller and paid with exchange equity will be treated as taxable boot, but items credited to the Taxpayer in a simultaneous exchange will be treated as cash paid by the Taxpayer and can offset the taxable boot from non-exchange expenses debited to the seller. This may not be the case in deferred exchanges.

To avoid possible taxable boot from prepaid rent and security deposits, it may be advisable to actually transfer these items to the buyer rather than have the buyer receive a credit against the purchase price.