Closing costs deductions on 1031 Exchange

We are often asked this question. Or perhaps it is asked, “Do I have to replace the net sales price or full sales price of the property I am selling to fully defer my tax?” Unfortunately, very little guidance (and it is fairly dated) has been provided in determining the deduction of transactional costs from any realized and recognized gain. Internal Revenue Service Form 8824 provides for transactional costs that are referred to as “exchange expenses” that can be deducted. But what are transactional costs?

Exchange expenses are those expenses which result solely as a result of the sale or acquisition of property and other costs directly related to the sale or acquisition of real estate or in connection with the 1031 Exchange (transaction expenses). These may include: real estate commissions, closing or escrow fees, title insurance premiums, legal fees, transfer taxes as well as such items as notary fees, recording fees and even the fee paid to your Qualified Intermediary.

One thing is clear. Costs related to obtaining financing should not be deducted from the proceeds to determine the "net sale price." Other transactional items typically found on a closing statement are not exchange expenses and probably do not reduce the amount realized or recognized and are not added to the basis of the replacement property. Items such as property taxes, utility escrow deposits or charges, homeowners' association fees, hazard insurance premiums, tenant security deposits and prepaid rents are items to look for on a closing statement.

When completing your tax return and determining how to report closing cost deductions, it will be extremely helpful to have your settlement statement as well as a form such as 1031 Corporation's Form 8824 worksheet. Of course, a taxpayer should review their individual transaction and closing costs with their tax and/or legal advisors to determine whether costs related to the closing are exchange expenses or not.