There has been a lot of development activity recently and investors who are doing an exchange and planning development on the replacement property might want to use exchange funds to pay some of those costs. In addition, investors who are borrowing money to acquire property may want to use exchange funds to pay loan fees. There are two completely separate issues to focus on when deciding to use exchange funds to pay costs and expenses related to the relinquished or replacement property.
CONSTRUCTIVE RECEIPT OF FUNDS
To create a valid exchange, the proceeds from the sale of the relinquished property have to go directly from the closing to the exchange intermediary. Once the intermediary has the exchange funds, the taxpayer can’t use the money, pledge it or benefit from the money. In addition, the funds can be used only to acquire the replacement property and pay certain expenses.
The 1031 regulations say that exchange funds can be used to pay “transactional items” that relate to the sale or the purchase and appear pursuant to local custom on the closing statement as the responsibility of a buyer or seller. Accordingly, depending on the local custom, these expenses that are typically shown on a closing statement can include broker’s commissions, exchange fees, title fees, transfer taxes and recording fees.
In most areas of the country, development costs such as architectural and entitlement fees are not paid at the closing or shown on the closing statement, and therefore should not be paid with exchange funds. Another example of this is rate lock-in fees paid to a lender, since they are paid prior to rather than at a closing.
If exchange funds are used to pay for something other than the purchase price or transactional expenses that are typically paid at the closing, these rules are violated and it has the potential to ruin the entire exchange.
Provided that you only use exchange funds to pay for the purchase price or transactional expenses that are typically paid at the closing, there is another issue to pay attention to. Certain expenses can be paid for with exchange funds but they will cause the exchange to be partially taxable.
For example, if a seller gives a buyer a credit against the purchase price for prepaid rent and security deposits, it won’t invalidate the exchange but will make it partially taxable, because the seller is really using exchange funds to pay for these costs, which are not exchange expenses. In addition, there are some loan fees that are typically paid at a closing, so using exchange funds won’t invalidate the exchange, but they may be considered costs of the loan rather than exchange expenses. That would result in the transaction being partially taxable.
In most areas of the country, development fees are not paid at the closing and therefore should not be paid with exchange funds. Loan fees that are typically paid at the closing can be paid with exchange funds, but doing so may make the exchange partially taxable. The one exception to being able to use exchange funds to pay loan fees is a rate lock-in fee, which is typically paid before a closing and therefore should not be paid with exchange money. It is a good idea to discuss these issues with your tax advisor and with First American Exchange prior to closing on the relinquished property. Planning will ensure that you have a valid exchange and adequate funds outside of the exchange to pay expenses.
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