By: James T. Walther, Esq., LL.M., General Counsel, and Todd R. Pajonas, Esq., President, Legal 1031 Exchange Services, LLC
The answer to this question is “it depends.” For some items, the guidance is pretty clear and for other items, the answer is open to interpretation due to the existence of limited IRS guidance.[i] While this short summary will briefly mention some existing rules/guidance/cases, it is important to note that in reality, custom and practice often deviate from these rules. Many 1031 exchanges are handled incorrectly with respect to transactional items because there is often little or no consequence for the improper handling. In general, it is rare that a taxing authority closely examines the settlement statement or closing disclosures. However, there is still a risk that a taxing authority could take issue with the use of exchange funds to pay for non-exchange costs. In most cases, the consequence is likely the payment of tax and penalty on the amount at issue, rather than disallowance of the entire exchange.
In the exchange context, there are three potential cost categories that can overlap, but have different implications: 1) allowable expenses (do not violate rules and do not trigger a tax consequence; 2) expenses that aren’t allowed and are treated as boot (can both trigger a tax consequence and violate 1031 rules – arguably invalidating part or all of an exchange); and 3) excepted transactional items, which are allowed and will not invalidate the exchange but are “boot” (taxable gain).
Allowable Exchange Expenses
Based on available guidance, and a consensus among tax experts, the following typical costs related to the disposition of real estate are allowable exchange expenses that can be paid out of the exchange proceeds in relation to relinquished or replacement property[ii]:
· Real estate commissions
· Title insurance premiums
· Closing or escrow fees
· Legal fees specifically related to the sale and purchase of exchange property.
· Transfer taxes
· Other costs specifically related to the transaction, such as Qualified Intermediary fees.
· Recording fees and Notary fees
· Environmental Studies
· Appraiser’s fees if related to acquisition due diligence and not a lender’s requirement
· Other due diligence costs if related to acquisition and not a lender’s requirement
These expenses are some of the more typical costs related to the disposition of real estate. In general, experts agree that an allowable expense should be any cost that reduces realized and recognized gain. In other words, it can be capitalized – added to the taxpayer’s adjusted basis for the property.[iii] The above list is not intended to be exhaustive and there could be other expenses that may qualify.
What Costs Aren’t Allowable Exchange Expenses?
Loan related fees/costs: Likewise, based on limited available guidance on the issue and past IRS positions, the consensus among many tax experts is that the following costs related to obtaining a loan, are not allowable exchange expenses which should not be paid out of the exchange proceeds:
· Lender’s title insurance premium
· Credit reports
· Pro-rated mortgage insurance
· Loan acquisition fees (such as points, mortgage insurance, application fees, lender’s title insurance, assumption fees, appraisal fees (specifically for loans), hazardous waste/property inspections (required by the lender)
Some experts argue that using exchange proceeds to pay costs related to financing will not violate the 1031 rules if obtaining a loan is a necessary and express condition in closing the real estate acquisition. If an exchanger wishes to take this position, they may be able to bolster their argument by converting financing related costs to contractual contingencies that must be reviewed, agreed, and occur, in order to complete the transaction.
Excepted or Disregarded Transactional Items
This final section discusses other common items that should be handled with care. The rules allow for an exchanger to pay for excepted or disregarded transactional items with exchange funds when doing so might not invalidate the exchange; however, should a taxing authority review the transaction, they may consider these items “boot” – taxable non-like kind property.
Treas. Reg. 1.1031k-1(g)(6) places limitations on the taxpayer’s ability to use funds held in the intermediary’s qualified escrow account during the exchange. However, as shown in the excerpts below, Treas. Reg. 1.1031k-1(g)(7) generally provides that the following categories of transactional items are exceptions to the limits in the sub-section (g) rules[iv]:
(i) Items that a seller may receive as a consequence of the disposition of property and that are not included in the amount realized from the disposition of property (e.g., prorated rents), and
(ii) 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 statements as the responsibility of a buyer or seller (e.g., commissions, prorated taxes, recording or transfer taxes, and title company fees). [Emphasis Added]
There is not a large body of binding authority interpreting what this rule would specifically except or disregard. It is easier to figure out what is not allowed and is boot.
Disallowed costs (non-transactional/boot) might include:
· Property taxes and legal fees related to tax appeals
· Prepaid rents and security deposits [v]*
· Code violations and related legal fees
· Utility service charges – i.e. water, sewer, electric bills
· Hazard insurance (if pro-rated as well)
· Mechanics liens and related legal fees
· Association fees
· Credits for lease deposits
· Cost of repairs related to the sale (“fixing up credits”)
· Architect Fees
· Environmental remediation*
· Tenant buy-out
* Some of these above items may be “customary” and might not invalidate the exchange; however, they are clearly not acquisition costs. See PLR 8328011 and for in depth analysis/examples, see In the Matter of the Appeal of Sawhney, 2017 WL 6612092 (Cal.St.Bd.Eq.).
The above costs are generally business operating expenses and are not transactional expenses that are related to disposition of real estate itself. Therefore, they do not offset gain, and they are not capitalized, that is, they are not added to the cost basis of acquiring the property. In essence, the taxpayer is using gains from the sale of real estate to pay for a business expense. The best practice would be to handle these costs separately from the 1031 exchange proceeds, because even though they could be considered “customary” for (g)(6) exception purposes, they are not considered allowable expenses; therefore, paying for them with exchange proceeds could trigger boot. A quick test for analyzing whether a cost is an allowable expense, would be to ask whether the cost would be incurred absent the requirements of a third party to the transaction, such as a lender, title company, tenant, or compliance with a local government’s code.
Exchangers should consult their advisor regarding this decision and regarding other costs in relation to a 1031 exchange transaction.
[i] Some of the relevant guidance on this issue includes, but is not limited to: Rev. Rul. 72-456, 1972-2 C.B. 468; PLR/TAM 8328011; Rev. Rul. 75-363, 1975-2, C.B. 463; Rev. Rul. 73-301, 1973-2 C.B. 215; Mercantile Trust Co. of Baltimore v. C.I.R., 32 B.T.A. 82, 1935 WL 138; Treas. Reg. 1.1031(d)-2; and Treas. Reg. 1.468B-6(b)(4).
[ii] See American Bar Association Section of Taxation “Comments Concerning Open Issues in Section 1031 Like- Kind Exchanges” Q.1, April 11, 1995.
[iii] See “Comments Concerning Open Issues in Section 1031 Like- Kind Exchanges”, Supra n. 2 (existing IRS guidance at the time of the Comment, 1995, dealt only with commissions as allowable expenses, but experts agree that its principles can be extended to all selling and exchange expenses incurred in either the disposition of the relinquished property or the acquisition of replacement property). “Under this logic, the IRC §1.263A-1 rules on uniform capitalization would provide helpful guidance, including examples of what costs can be capitalized.”
[iv] Treas. Reg. 1.1031(g)(6) provides that in order to have a valid exchange, the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property before the end of the exchange period must be expressly limited by agreement (a QI must effectively limit how and when the taxpayer can receive proceeds). Sections (g)(3) to (g)(5) of the regulations provide additional “safe-harbors” for taxpayers to follow.
[v] TAM/PLR 8328011– addresses netting mortgage and non-mortgage/unsecured liabilities in a two-party exchange of multiple properties. The ruling states that accrued interest and property taxes, which were unsecured liabilities assumed by the buyer, could be netted against other liabilities; however, security deposits and pre-paid rents are generally not treated as liabilities for tax purposes and cannot be netted. The law treats these items like a grantor trust and the transfer of a security deposit from one landlord to another is the equivalent of a substitution of fiduciaries. See also Rev. Rul. 75-363, 1975-2, C.B. 463; Rev. Rul. 73-301, 1973-2 C.B. 215 (landlord acts as a fiduciary while holding deposits and prepaid rent – deferred credits are pre-paid income contingent on vesting and should not be treated as a liability for purposes of Section 1031). It is unclear whether the reasoning in TAM 8328011 applies to netting non-mortgage liabilities in a deferred exchange involving an intermediary. But See PLR 9853028 which held that for netting purposes indebtedness paid off by the buyer in a deferred exchange rather than an assumption by the buyer, is treated as liability boot that can be offset and does not result in constructive receipt by the seller. Other guidance, Treas. Reg. §1.1031(j)-1(b)(2)(ii)(A) and PLR 201648013 address the issue of netting unsecured liabilities with new debt on the replacement property; however, the applicability of this guidance might be exclusive to “Exchange Programs” involving multiple properties.
The short version of this article can be found here.
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