FGG is pleased to provide this timely guest blog previously written By Lisa Villarreal, Business Development Manager at First American Exchange Company. First American Exchange Company provides 1031 exchange Qualified Intermediary services nationwide and is a direct subsidiary of First American Title Insurance Company.
Avoid Mistakes That May Impact Your Exchange
The success of a taxpayer’s tax deferred 1031 exchange depends on the taxpayer’s acquired replacement property being of equal to or greater value than the property the taxpayer sold (the relinquished property). The taxpayer must invest all their exchange proceeds into the replacement property, and balance any debt paid off on the relinquished property by obtaining an equal or greater amount of financing on the replacement property (or by investing outside equity equal or greater to the relinquished property’s debt). What is often misunderstood or overlooked by taxpayers, however, is that using sales proceeds (i.e., exchange proceeds) to pay for certain expenses at the closing of the relinquished property can result in the transaction being partially taxable, even if the taxpayer “purchases up” in value. In some cases, it could even result in the taxpayer being in constructive receipt of funds, which can be fatal to a 1031 exchange’s success.
Allowable Exchange Expenses*
Certain expenses paid at closing are considered “exchange expenses” and using exchange funds to cover those costs will not result in tax liability to an exchanging party. The IRS has not been explicit on the exact costs that do and do not constitute exchange expenses. However, in Revenue Ruling 72-456, the IRS stated that it would not consider exchange funds used to pay brokers’ commissions to be taxable. Most tax advisors agree that the following expenses are considered allowable exchange expenses that may be paid at the closing of the relinquished or replacement property without any negative tax consequence:
- Brokers’ 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
Other expenses are not considered exchange expenses. Exchange funds may be used to pay for some non-exchange expenses at closing without the taxpayer being in constructive receipt of funds (more on this, below), so long as they are costs that customarily appear on closing statements as the responsibility of buyer or seller. However, doing so may still result in the exchange being partially taxable. In other words, a taxpayer may have tax liability in the amount of any items paid at closing with exchange proceeds that are not considered allowable exchange expenses as outlined above.
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
Most tax advisors take the position that any fees and costs incurred in connection with obtaining a loan to acquire replacement property are considered costs of obtaining the loan, not costs of purchasing the replacement property. Therefore, under tax law, these costs would not be considered exchange expenses. If the taxpayer uses exchange funds at the closing of the replacement property to cover loan costs and fees, it is likely that doing so will create some tax liability. To avoid this result, the taxpayer may consider depositing outside cash into the closing to pay for any loan-related expenses.
Handling Rents & Security Deposits at Closing
Security deposits and prorated rents, while commonly found on settlement statements for the sale or purchase of investment property, are not considered allowable exchange expenses. If closing funds are used to pay for these costs, the taxpayer will have tax liability on the amount of rents and security deposits paid through closing. Therefore, it is important for a seller conducting a 1031 exchange to understand how those credits will affect the seller’s exchange outcome.
Since prorated rents and security deposits are not “exchange expenses,” using exchange funds to cover these costs at closing will cause the transaction to be partially taxable. Providing the buyer a credit is equivalent to using sales proceeds, i.e. exchange funds, to pay the buyer an amount equal to the credit. As a result, fewer proceeds from the sale are available to the seller at closing to utilize toward the purchase of their replacement property.
For example, if a taxpayer sells property for $5 million and owes the buyer $100,000 in prorated rents and security deposits, the taxpayer will typically provide the buyer a credit for $100,000, resulting in the buyer effectively paying the seller $4.9 million instead of $5 million (this example ignores other costs likely to be involved). The closing agent would send $4.9 million to First American Exchange Company as Qualified Intermediary as exchange proceeds, which would be used to acquire the taxpayer’s identified replacement property. Since the total potential sales proceeds / exchange funds from the relinquished property sale were $5 million, but only $4.9 million would be available to acquire the replacement property, the transaction would be taxable up to the $100,000 that was used to pay the buyer credit (even if all other proceeds are reinvested in replacement property).
A work-around is for a seller to come up with their own funds to pay these non-exchange expenses directly to the buyer. The costs can be handled outside of closing, or the seller can bring the funds into the closing to cover these amounts, resulting in the full amount of exchange proceeds being wired to the exchange account at closing. These strategies can be used to avoid having a taxable consequence for any non-exchange expense, whether prorated security deposits or rentals, or credits to be given to the buyer for prorated property taxes.
Transactional Items and Constructive Receipt
A separate, but important, issue is whether paying certain expenses at closing will show that the taxpayer has constructive receipt of their exchange funds, which could potentially render the entire exchange invalid. Exchange funds may be used to purchase the replacement property, including making deposits, and to pay for typical costs related to the sale or purchase of relinquished or replacement property, such as prorated rents and broker commissions. As a general rule, as briefly discussed above, exchange funds can be used to pay for “transactional items that relate to the disposition of the relinquished property or to the acquisition of the replacement property and appear under local standards in the typical closing statement as the responsibility of a buyer or seller (e.g., commissions, prorated taxes, recording or transfer taxes, and title company fees).”
Because of the wording of the regulations, costs that are not typically paid on a closing statement in the area where the property is located, and costs that are unrelated to the sale or purchase, may trigger a constructive receipt issue if exchange funds are used to cover them. In addition, because of the wording of this rule, many tax advisors caution against paying expenses with exchange funds in between the closing of the relinquished and replacement properties.
One common situation where this issue arises is when an investor wants to use exchange funds to pay rate lock-in fees to a lender. Since these fees by their nature are paid before the closing to lock in an interest rate, they do not “appear under local standards in the typical closing statement,” and therefore may trigger a constructive receipt issue. Similarly, it can be tempting for a seller to include certain credits to the buyer for repairs or improvement costs made to a relinquished property, or to include other items such as payoffs of loans or debts that are not secured by or related to the relinquished property, on the closing statement. Since there is no clear IRS interpretation of this rule, investors need to discuss the issue with their tax advisors before paying unrelated expenses at a closing, or any expenses in between closings.
It is advisable to always have your tax advisor review the numbers on your closing statement(s) prior to closing. That will ensure that you have a good sense of the net proceeds you will be working with when acquiring replacement property, and whether you will have a fully tax-deferred exchange or have any taxable expenses to take into account.
For more information on 1031 Exchange tax deferral strategies, please contact First Guardian Group at 866 398-1031 or info@FirstGuardianGroup.com.
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*References: Revenue Ruling 72-456; Treasury Regulation Section 1.1031(k)-1(g)(6) and (7); IRS Form 8824.