Here’ a question I get asked at least once a week:
“How can I reduce the price of what I am going to purchase as my Replacement Property?“
Well, there are a number of “exchange expenses” that will reduce the realized gain and recognized gain on a Section 1031 Exchange. The real estate commission paid by the taxpayer to a real estate broker is an example of one such deductible expense.
Deductible Here Is Your Comprehensive Guide To Deductible 1031 Expenses.
Understanding Deductible Expenses: Revenue Ruling 72-456 serves as a cornerstone in the realm of 1031 Exchanges, clarifying that certain expenses, when paid using exchange funds, do not render the transaction partially taxable. These expenses include:
- The Broker’s Commissions: Perhaps one of the most significant expenses in a real estate transaction, broker’s commissions are fully deductible when paid using 1031 exchange proceeds.
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Exchange Fees: Fees associated with facilitating the exchange process, such as intermediary fees, fall under the umbrella of deductible closing expenses.
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Title Insurance Fees (Owner’s Policy): Protecting ownership rights is paramount in real estate transactions. Consequently, fees for the owner’s policy of title insurance are considered exchange expenses.
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Escrow Fees: The costs incurred for escrow services, ensuring a smooth and secure transaction, are deductible when paid using exchange funds.
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Appraisal Fees: When appraisal fees are required by the purchase contract, they qualify as deductible expenses, contributing to the overall cost of the exchange.
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Transfer Taxes: Taxes levied on the transfer of property ownership, such as stamp duties, are eligible for payment using 1031 exchange proceeds.
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Recording Fees: The fees associated with recording legal documents related to the transfer of property are considered deductible closing expenses.
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Attorney’s Fees: Legal fees incurred in connection with the sale or purchase of the property are deductible, provided they are directly related to the exchange process.
Navigating Non-Exchange Expenses:
While the aforementioned expenses are clearly deductible, certain costs commonly found on closing statements do not qualify as exchange expenses.
However, some of these expenses may still provide tax benefits through deductions:
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Property Taxes: While property taxes are not considered exchange expenses, investors can still benefit from deductions when paying them, thereby offsetting the tax liability.
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Loan Costs and Fees: Expenses associated with obtaining financing, such as loan origination fees and points, are typically not deductible as exchange expenses.
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Title Insurance Fees (Lender’s Policy): Unlike fees for the owner’s policy, fees for lender’s title insurance policy are generally not considered exchange expenses.
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Appraisal and Environmental Investigation Costs (Lender Requirements): Costs incurred for appraisals and environmental investigations mandated by the lender fall outside the scope of deductible closing expenses.
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Security Deposits and Prorated Rents: These expenses, while common in real estate transactions, are typically not considered exchange expenses eligible for payment using 1031 exchange proceeds.
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Insurance Premiums: Costs associated with property insurance premiums do not qualify as exchange expenses and are thus not deductible in the context of a 1031 exchange.
Let me provide an example:
Example of Deductible and Non-Deductible Exchange Expenses
A Taxpayer originally purchased an apartment building for $975,000.00 in 2012. The taxpayer sells the building in 2021 for $2,300,000.00 and has an initial gross profit of $1,325,000.00.
He was instructed to do a Section 1031 tax-deferred exchange and that he would have to purchase a Replacement Property of equal value or more than the Relinquished Property, which as we have already said he sold for $2,300,000.00.
If he did not do a section 1031 exchange, he would have to pay long-term capital gains taxes of 20%, plus 25% federal deprecation recapture tax and any state taxes. Just on the long-term capital gains taxes, the taxpayer would have to pay 20% on $1,325,000.00 = $265,000.00. Of course, there are the additional taxes due to the state and federal depreciation recapture taxes to deal with.
On the Relinquished transaction, the taxpayer hired a real estate broker whose commission was $115,000.00. The state charged $16,100.00 for transfer fees. There were $595.00 in title search fees and his CPA charged him $2,500.00 for analyzing and advising on the transaction. He also was responsible for an updated survey which cost $600.00 and there were $120.00 in recording fees.
The taxpayer’s share of the real estate taxes for the year were $26,500.00.
He has paid his Attorney/Escrow Agent the sum of $3,000.00 to represent him on this transaction.
There was an existing loan on the property that had to be paid off in the amount of $455,000.00. Additionally, there was interest owed on the loan of $9,700.00.
So, that leaves the big question: How much Replacement property does the taxpayer have to purchase, in order to defer paying any taxes, to the Federal and/or State Governments?
Allowable Exchange Expenses
Real Estate Commission $115,000.00
State Transfer Fees $ 16,100.00
Tile Search Fee $ 595.00
CPA Charge $ 2,500.00
Attorney/Escrow Co. Fee $ 3,000.00
Survey $ 600.00
Recording Fees $ 120.00
Total Allowable Exchange Expenses $137,915.00
REPLACEMENT PROPERTY $ AMOUNT IF TAXPAYER WANTS TO DEFER ALL TAXES IS: $2,162,085.00.
How did we arrive at that figure? Sales Price of $2,300,000.00 less $137,915.00 in allowable exchange expenses = $2,162,085.00.
Non-Allowed Exchange Expenses:
Real Estate Taxes $ 26,500.00
Loan Payoff $ 455,000.00
Interest Owed $ 9,700.00
Total of Non-Allowed Exchange Expenses: $491,200.00*
* Of the Non-Allowed Exchange Expenses, both the Real Estate Taxes of $ 26,500.00 and the Interest Owed, in the amount of $9,700.00 are allowed as deductions to profit, just not figured into the amount of what the new Replacement Property figure would be.
As you can see from the example, it is ALWAYS a good idea to hire a competent attorney, a CPA, and a Qualified Intermediary, to assist the Taxpayer on a Section 1031 exchange.
Affiliated 1031, LLC always recommends that the taxpayer should consult their tax and/or legal counsel on all matters dealing with the Internal Revenue Service.
