By Jerry Feeney Esq. and Daniel Mendoza

Qualified vs Unqualified Closing Costs

One of the most common mistakes taxpayers make in a 1031 exchange is using exchange proceeds to pay unqualified closing costs.

This minefield can cause unexpected tax bills for even the most careful exchanger.

Let’s take a look at what can happen.  Suppose you are doing the “sell” side of the exchange, the “relinquished property,” and your settlement agent adds a line item to the closing statement for pro rated rent and security deposit owed to the buyer.  The property you are selling is an investment property, and there is a tenant in place, so you need to account for collected rent and security deposit held when selling.  Suppose the rent and security are each $1,000, and you are closing in the middle of the month.  The tenant paid the rent on the first, so you owe your buyer $500 in prepaid rent, and the full amount of the security you are holding, or $1,000.  Can you simply give buyer a “credit” of $1,500 from the sale and call it a day?

You can, but this will be considered “boot” because you are using exchange proceeds (e.g. the proceeds from the sale) to pay outside expenses.  The rent adjustment should come from outside the closing, with funds you deposit prior to closing with the settlement agent.  Those funds were paid to you prior to the closing and you should now reimburse them to the settlement agent, in order to provide the adjustment to the buyer.  Otherwise, this is no different than you “pulling” proceeds from the sale and depositing them into your account, which is a violation of 1031 exchange rules and would result in a taxable event with respect to that amount (here, $1,500).

In a 1031 exchange all closing fees are divided into qualified and unqualified expenses. 1031 exchange proceeds can be used to satisfy only qualified expenses in both closings (relinquish and replacement).  Exchange proceeds used for unqualified expenses are considered “boot” and are taxable, eating away from the full benefit of the 1031 exchange, and creating unnecessary tax obligations.  We discuss boot more fully in “An Exchanger’s Guide to Boot”.

Best practices to avoid tax exposure from unqualified expenses:

• Prior to closing date have your qualified intermediary review your settlement statement for boot.
• Be prepared to add personal funds to a transaction to satisfy unqualified closing costs.
• Prior to closing either side of the transaction always consult with your tax adviser.

Below is a sample list of qualified and unqualified closing costs in a 1031 Exchange.

Qualified expenses

• • Broker’s commissions
  • Exchange fees
  • Title insurance fees for the owner’s policy of title insurance
  • Escrow fees
  • Transfer taxes
  • Recording fees
  • Attorney’s fees

Unqualified expenses

• • Loan expenses 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
  • Homeowner association (HOA) dues
  • Repair and improvement expenses