As we discussed in the April 2009 issue of this newsletter, certain expenses, such as broker commissions, transfer taxes and exchange fees, are considered costs incurred in connection with the sale of the relinquished property or the purchase of the replacement property, and can be paid at the closing of the relinquished or replacement property using exchange funds, with no adverse tax effect on the seller.  Using exchange funds to pay other items, such as prorated rent, may make the transaction partially taxable.   

Constructive Receipt Issue

A separate, but important, issue is whether paying an expense with exchange proceeds during an exchange will show that the investor has constructive receipt of the exchange funds, which has the potential to ruin the entire exchange.  Under the constructive receipt rules, exchange funds can be used to:

• Make deposits on the replacement property,
• Pay the purchase price of the replacement property, and
• Pay costs and expenses related to the sale of the relinquished or purchase of the replacement property that typically appear on a closing statement as the responsibility of the buyer or seller.

Because of this rule, investors should use caution before using exchange funds to pay costs that are not typically paid at a closing (such as interest rate lock-in fees, since they are typically paid to the lender well in advance of the closing).  

Tips for the Investor

Investors should focus on two issues when deciding how to pay expenses that are incurred when selling the relinquished property or buying the replacement property:

• Is this category of expense typically shown on a closing statement for the sale of the relinquished property or purchase of the replacement property as the responsibility of the seller or buyer? If the answer is no, then using exchange funds to pay it could ruin the investor’s exchange. If the answer is yes, then there should not be a constructive receipt problem, and the investor should consider the next question about whether paying that expense with exchange funds could create boot (i.e., make the exchange partially taxable).
• Is the cost an “exchange expense”? If under tax law the expense is considered a cost incurred in connection with the sale or purchase of property, it is an exchange expense and using exchange funds to pay it won’t make the exchange partially taxable. If the expense is not considered a cost incurred in connection with the sale or purchase of property, using exchange proceeds to pay it may result in some boot to the taxpayer.

Giving the purchaser of the relinquished property a credit for an item (like prorated rents and security deposits) is the same as using exchange funds to pay for that item.  Prorated rents and security deposits are typically shown on a closing statement as the obligation of the seller or buyer, so they should not create a constructive receipt problem.  On the other hand, for tax purposes, neither prorated rents nor security deposits are an “exchange expense” so if the seller of the relinquished property gives the buyer a credit for those, the exchange may be partially taxable to the extent of the prorated rents and security deposits. 

Conclusion

If you are planning an exchange in the near future, we recommend that you call First American Exchange to discuss these issues.  We can also send you our prior newsletter with more information about exchange expenses.  In addition, it’s important to discuss this with your tax advisor and have your advisor review the expenses that are to be paid on your closing statements before you close on the sale of the relinquished or purchase of the replacement property.