Closing Costs: Allowable and Non-Allowable Expenses

ALLOWABLE EXCHANGE EXPENSES

Certain expenses paid at closing are considered “Allowable Exchange Expenses” and using exchange funds to pay those expenses won’t result in any tax liability to an investor doing a 1031 exchange. For example, Revenue Ruling 72-456 provides that if exchange funds are used to pay broker’s commissions, it does not result in the transaction being partially taxable. There are no other clear rulings on this subject, but 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 tax consequence: 

• Broker Commissions

• Real Estate Agent Commissions

• 1031 Qualified Intermediary Exchange Fees

• Title Transfer Fees

• Escrow Fees

• Appraisal fees required by the purchase contract

• Transfer Taxes

• Recording Fees

• Attorney’s / Tax Advisor fees incurred in connection with the sale or purchase
  
  

NON-ALLOWABLE EXCHANGE EXPENSES

All other expenses are considered “Non-Allowable Expenses”. For example, security deposits and prorated rents are not considered exchange expenses and 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 (exchanger) should deliver their own out of pocket funds directly to the buyer as Paid Outside of Closing (POC) to cover the security deposits and prorated rents. 

In addition, the fees and costs in connection with getting a loan to acquire the replacement property are costs of the loan, not costs of purchasing the replacement property, and therefore under tax law are Non-Allowable exchange expenses. If the investor uses exchange funds at the closing of the replacement property to pay loan costs and fees, it is likely by doing so will create a tax liability. To avoid the tax liability, the exchanger may choose to pay for any loan related costs out of their pocket. 

The following is a list of expenses that are typically found on a closing statement and are generally considered Non-Allowable Exchange Expenses:

• Maintenance Costs (credits to Buyer for repairs)

• Loan Costs and any Fees associated with a Lender

• Title insurance fees for lender’s title insurance policy

• Appraisal and environmental investigation costs that are required by the lender

• Security Deposits

• Prepaid / Prorated Rents

• Insurance Premiums

• Property Taxes

• Utility Charges

• HOA Fees

• Unsecured Debts (Loans not secured by the subject property being sold)
  
  

TRANSACTIONAL ITEMS AND CONSTRUCTIVE RECEIPT

Costs that are unrelated to the sale or purchase, may trigger a constructive receipt problem if exchange funds are used to pay them, therefore QI’s abide by the (g)(6) Treasury Regulations and only send exchange funds to the closing agent handling the transaction. In addition, many tax advisors caution against paying expenses with exchange funds in between the closing of the relinquished and replacement properties as they could jeopardize the entire exchange.

One common situation where this issue arises is when an exchanger 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 problem.

CLOSING “SETTLEMENT STATEMENT”

In real estate transactions, the parties use closing statements, or escrow agreements, to memorialize purchase-and-sales agreement terms. The closing statement's focus is the price, but the contract can stipulate other items - such as prorated rents and property taxes, escrow account buyouts, security deposit transfers, or prepaid service contract reimbursements - that the settlement statement commonly reflects. Typically the settlement statement also shows closing costs such as attorneys' fees, real estate commissions, or transfer taxes associated with the sale. Items shown as a cost to the seller become a debit on the settlement statement and reduce the amount of proceeds available after the sale.

In exchanges, settlement statement costs to the seller reduce exchange proceeds. In addition, the IRS treats non-allowable exchange expenses charged to the seller as taxable items. Some of the more common non-allowable exchange items include prorated rents, security deposit transfers, and loan fees. For example, a relinquished property is a rental building with an existing tenant, and the contract stipulates that the seller transfer the security deposit to the new owner.

In this situation, the IRS does not consider the security deposit a closing cost; it simply is an additional business item that happens to be associated with the sales contract. However, if the settlement statement charges the security deposit amount against the seller, the debit reduces the exchange proceeds amount. The seller probably delineates this reduction on his 8824 exchange reporting form, which requires him to pay taxes on the amount. As this example demonstrates, sellers should strive to minimize non-allowable exchange expenses during 1031 exchange closings.

CONCLUSION

Further, any financing or lender costs and other costs (Non-Allowable Expenses) not related to the direct acquisition of the replacement property(ies) can only be paid at the close of the replacement property(ies) when the Qualified Intermediary (Accommodator) disburses all of the 1031 Exchange funds it is holding to the closing agent. Keep in mind, Non-Allowable Expenses are taxable if paid with exchange funds at the closing of the transaction.

REFERENCES

Revenue Ruling 72-456; Treasury Regulation Section 1.1031(k)-1(g)(6) and (7); IRS Form 8824.