Section 1031 of the Internal Revenue Code has been used by sellers of commercial or investment real estate to defer the recognition of capital gains tax arising from the sale of the property. In a non-simultaneous exchange, this is accomplished by the seller transferring the proceeds of the sale to a Qualified Intermediary, and then later using the proceeds of the sale to purchase another like-kind parcel of real estate (property of the same nature, character or class as the property that was originally sold). If the seller follows the procedures required under the Code, then the amount of proceeds utilized to purchase the like-kind property will not be taxable at the time of the sale or the exchange.
A seller utilizing the 1031 exchange is not required to find like-kind property in the exact dollar amount as the proceeds received from the original sale, instead the seller can use a portion of the proceeds for the purchase of the like-kind property while receiving the remainder of the excess funds personally; however any excess amount not used in the purchase of like-kind property shall be treated as taxable by the IRS. Any property a seller received from the sale of real estate that is not like-kind property, including excess cash from the proceeds of a sale, is referred to as “boot” and the seller will incur taxes as a result of including the “boot” in income.
Experienced buyers of real estate understand that there are additional costs and expenses spent pursuant to acquiring property beyond just the purchase price. These costs include but are not limited to inspections, environmental reports, surveys, repair work, title insurance and legal fees, and loan fees. There is little authority on whether the use of exchange funds towards these transactional costs are considered included with the purchase of like-kind property or whether such expenses are considered outside the definition of like-kind property and result in tax consequences for the seller.
Treasury Regulation §1.1031(k)-1(g)(7) provides that transaction items that appear under local standards in the typical closing statement as the responsibility of a buyer or seller may be paid from exchange funds. Furthermore, in Revenue Ruling 72-456 the IRS allowed a real estate broker commission to be deducted from exchange funds and not be considered boot because brokerage commissions reduce the realized gain of a taxpayer and increases the tax basis for the acquired replacement property. The reasoning of Revenue Ruling 72-456 can be applied to any non-recurring closing cost, and that all costs that reduce recognized gain and increase the tax basis of the replacement property should be applicable costs to be paid from exchange funds. It is for these reasons that most tax practitioners consider the following transaction expenses to be allowable, and not result in boot for the seller, if used from exchange funds:
- Real Estate Brokerage Commissions;
- Legal Fees;
- Escrow, Processing and Statement Fees;
- Finder Fees;
- Qualified Intermediary Fees;
- Inspection and Testing Fees;
- Notary and Recording Fees;
- Title Insurance Fees (except not for a lender policy); and
- Transfer Taxes.
Transactional costs may result in boot if such costs result in benefits other than acquiring the like-kind property. Expenses incurred pursuant to obtaining a mortgage such as lender fees, mortgage points, loan appraisal fees, lender title insurance, and any inspections required to be made by a lender (and not an inspection agreed-upon by the parties within a purchase and sale agreement) are not considered costs of acquiring like-kind property and would be boot. The same principal applies to obtaining insurance for the like-kind property other than title insurance. Prorated property taxes, rents and security deposits are also viewed as costs that are not included in acquiring the like-kind property and could result in boot, however the buyer of the like-kind property can negotiate with the seller to have such payments credited to buyer at closing and, thus, no expenses would need to be spent from the exchange funds. It is important to note, though, that transaction costs that do not qualify to be made from exchange funds may still be deductible as expenses in the operation of the newly acquired property.
A seller who wishes to utilize the benefits of the 1031 exchange should be aware which expenses can be made from exchange funds and which expenses that would result in tax consequences. We are experienced in assisting clients with 1031 exchanges and can provide the necessary information so clients execute a successful exchange. Please feel free to give our office a call with any questions you may have regarding 1031 exchanges or other matters concerning the purchase or sale of real estate.
If you have any questions in this area, please contact:
Morris R. Saunders at:
email@example.com or 312-368-0100.