How to Find Hidden Boot in a 1031 Exchange
Many investors know that in order to have a completely tax deferred 1031 exchange, they need to acquire replacement property that is equal or greater in value compared to what was sold, and they need to use up all of their cash. What is not understood as well is that using exchange money to pay for certain expenses at a closing can result in the transaction being partially taxable.
Exchange Expenses
Certain expenses paid at a closing are considered “exchange expenses” and using exchange funds to pay those expenses won’t result in any tax liability to an investor doing a 1031 exchange. There are almost no official IRS rulings on this issue, but in Revenue Ruling 72-456 the IRS said that if exchange funds are used to pay broker’s commissions, it will not make the transaction partially taxable. Most tax advisors agree that the following expenses are exchange expenses and may be paid at the closing of the relinquished or replacement properties without any negative tax consequence:
- Broker’s commissions
- Exchange fees paid to a qualified intermediary
- Title insurance fees for the owner’s policy of title insurance
- Escrow fees
- Appraisal fees for an appraisal required by the purchase contract
- Transfer taxes
- Recording fees
- Attorney’s fees incurred in connection with the sale or purchase of the property
Non-Exchange Expenses
Other expenses are not exchange expenses, so although exchange funds can be used to pay the expense (provided it is an expense that is typically paid at a closing), doing so may result in the exchange being partially taxable. For example, security deposits and prorated rents are not exchange expenses. If exchange funds are used to pay them, the exchange will be partially taxable. This comes up when the seller of the relinquished property gives the buyer a credit at the closing for the security deposits and prorated rents. The result of the credit is as if the seller was using exchange funds to pay the security deposit and prorated rent amounts to the buyer. To avoid the tax, the seller should use his own funds to pay those security deposits and prorated rents to the buyer.
In addition, most tax advisors believe that fees and costs in connection with getting the loan to acquire the replacement property are costs of the loan, not costs of purchasing the replacement property, and, therefore, under tax law are not exchange expenses. If the investor uses exchange funds at the closing of the replacement property to pay loan costs and fees, it is likely that doing so will create a tax liability. To avoid the tax liability, the buyer may want to deposit his own funds to pay any loan related expenses.
The following is a list of expenses that are typically found on a closing statement but are generally not considered exchange expenses:
- Loan costs and fees
- Title insurance fees for lender’s title insurance policy
- Appraisal and environmental investigation costs that are required by the lender
- Security deposits
- Prorated rents
- Insurance premiums
- Property taxes
Constructive Receipt
A separate, but important, issue is whether paying an expense will show that the investor has constructive receipt of the exchange funds, which has the potential to ruin the entire exchange. This issue will be discussed in a subsequent newsletter, but if you have any questions about this or any other 1031 issue, feel free to contact us.
References: Revenue Ruling 72-456; Treasury Regulation Section 1.1031(k)-1(g)(6) and (7); IRS Form 8824.
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