What to do about expenses in a §1031 Exchange?
In order to obtain complete deferral of capital gain taxes in an exchange otherwise meeting the requirements of Internal Revenue Code §1031, a taxpayer is generally required to reinvest all net sale proceeds generated by the sale of relinquished property in like-kind replacement property within the applicable exchange period (a maximum 180 calendar days). In addition, the taxpayer must not have a
direct or indirect right to receive or otherwise obtain the benefit of the exchange proceeds during the exchange period except to acquire like-kind replacement property. Any non like-kind property received by the taxpayer in the exchange, usually referred to as boot, will cause the taxpayer to recognize gain. Under the foregoing rules, the use of exchange funds to pay expenses not related to the exchange could invalidate the exchange to the extent such use results in the taxpayer’s constructive receipt of exchange proceeds. In other cases, payment of an expense related to the disposition of relinquished property or acquisition of replacement property may give rise to taxable boot in the exchange but would not create a constructive receipt problem. Finally, payment of certain costs related to the transfer of the relinquished property that may be characterized as selling expenses or exchange expenses are excluded from the seller’s amount realized and ignored altogether. Treasury Regulation §1.1031(k)-1(g)(7) permits certain transactional expenses related to the exchange transaction to be paid from exchange proceeds without disqualifying the exchange. These include 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 statements as the responsibility of a buyer or seller (e.g., commissions, prorated taxes, recording or transfer taxes, and title company fees). See also Letter Ruling 8328011. Similarly, proposed regulation §1.468B-6(b) states that transactional expenses are “the usual and customary expenses paid or incurred in connection with a deferred exchange. For example, the costs of land surveys, appraisals, title examinations, termite inspections, transfer taxes, and recording fees are transactional expenses.” While the payment of transactional expenses out of proceeds will not disqualify an exchange, payment of such items out of exchange proceeds may generate boot resulting in the recognition of some taxable gain. Thus, a careful review of the closing statements on the relinquished property sale and the replacement property purchase before closing is strongly recommended. Often an item that would generate boot can be dealt with in a way that will avoid characterization as boot. Part 2 of this Article to Appear in the Next Edition of the Mid Atlantic Real Estate JournalPamela Michaels is an attorney and VP of Asset Preservation, Inc. and can be reached at 866-317-1031 or at email@example.com.
For more information about 1031 exchanges, visit www.apiexchange.com. As a "Qualified Intermediary" as defined in the Section 1031 regulations, Asset Preservation, Inc. is not able to provide legal or tax advice. Accordingly, you should review the details of your specific transaction with your own legal or tax advisor.