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.

Where Does Your Intermediary Put Your Exchange Funds?

We've spoke before of the need to fully investigate the Qualified Intermediary (QI) you, as an investor or a referring agent, choose. Some high profile cases have identified the need to deal with a QI you know and trust. Even that is sometimes not enough and you should really investigate the safety and security of the company you use.

As we've said before, the range of investments a Qualified Intermediary can make with your exchange funds is not currently regulated. Your QI can place your exchange funds in many different investment vehicles. Knowing how your exchange funds are protected is vital when selecting an intermediary partner. Most, but not all, QIs place your 1031 exchange proceeds in financial institution. Others choose to pool the funds and place them with an investment firm that offers short term liquidity such as overnight borrowing vehicles.

While we've previously explored the security features of bonding and making sure you deal with a firm that is financially stable and uses segregated accounts. However, we haven't discussed knowing the financial strength of the institution with which the Qualified Intermediary banks your funds. With recent news of bank capital calls, troubled financial institutions and even failures like Indy Mac, you should ask the question of where your funds are held.

Some of the questions you should ask include:

Are your exchange proceeds placed in a segregated account or are they pooled with other exchange client funds?

How well capitalized is the bank or financial firm your Qualified Intermediary uses?

Can you find information of the bank or investment firm?

Has there been any recent news about trouble such as capital calls, bad loans or subprime lending participation with the financial institution?

Does the bank or investment firm provide independent depositor insurance such as FDIC coverage?

Does your Qualified Intermediary offer the ability to split your exchange funds into multiple accounts to provide deposit insurance protection?

Our firm has always segregated funds and held them in a bank account. We are a subsidiary of FirstBank. They hold more than $9.2 billion in assets, have a low loan-to-deposit ratio of around 42% and are extremely well capitalized. Further, they are profitable today having a very low percentage of problem loans and have never participated in subprime mortgage lending. In fact, the health of the bank was just highlighted in both a Rocky Mountain News article and a Denver Post article. We also have the ability to split accounts into 26 separately chartered banks of the bank. This provides our clients with up to $6.5 million in FDIC insurance.

You should expect the same level of security and safety in your 1031 exchange funds. After all, it's your money they are holding. If your Qualified Intermediary can not answer these simple questions of where the money is held, or the answers aren't sufficient to provide you peace of mind, it's time to look for a new QI.

Oil, Gas and Mineral Interest 1031 Exchanges

It would seem to make sense that you could exchange a working or royalty interest for another working or royalty interest as part of a 1031 Exchange. But, did you know that you can also exchange a working or royalty interest for other real estate? For example, if you sell a working interest, you could replace it with another working interest, a royalty interest, or ownership in an office building, apartment building, or other real estate.

However, oil, gas and mineral interest exchanges are tricky. For example, if you sell a working interest and retain the royalty interests or surface rights, the IRS may disallow your exchange. This is because production payments do not qualify for a 1031 Exchange.

The sale of working interests often involves the sale of related equipment. Keep in mind that transfers of equipment require the equipment to be treated as a separate personal property exchange. Personal property exchanges are a different animal than real estate exchanges.

Also note that any costs incurred to drill and develop the gas or mineral site must be recaptured to the extent that you do not re-acquire qualified natural resource property. In other words, if you sell a working interest in a gas well and buy an office building, you would have to "recapture" the Intangible Drilling Costs (IDC) costs you had previously deducted.

If you have questions about Oil, Gas or Mineral interests and how they relate to 1031 exchanges, please contact 1031 Corporation Exchange Professionals at 888-367-1031.