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Closing Costs and the Tax Deferred Exchange...
Exchangers, closing agents, escrow
officers and tax advisors have struggled with the many issues presented by the variety of
expenses and cash payments associated with closing the properties in n exchange
transaction. To make matters less certain, there is little authority in the Internal
Revenue Code or Treasury Regulations as to how to treat the closing cost items commonly
seen on settlement statements. The following are answers based on existing authority to
typical issues seen on settlement statements.
Given the general rule that an Exchanger
must transfer all equity in the relinquished property to the replacement property, the
issue is whether the Exchanger will be taxed on the amount of the sale proceeds used to
pay typical sale and purchase settlement expenses.
 | Revenue Ruling 72-456 that specifies the real estate sale
commissions paid is offset against the sale proceeds received provides some guidance. The
purchase commissions paid are added to the basis of the replacement property. Therefore,
payment of brokerage commissions from exchange proceeds does not create taxable boot. |
| Based on this rationale, the same favorable treatment may be
accorded other sale and purchase expenses. Payment of the following
"non-recurring" costs of sale or purchase from the exchange proceeds should not
create taxable boot: |
Real estate commissions Documentary
transfer taxes
Title insurance premiums Direct legal fees
Escrow or closing agent fees Agreed
property inspections
Recording fees Intermediary fees
| However, certain costs may create taxable boot because they
are seen as expenditures for benefits other than acquiring the replacement property. Loan
fees, points and prorated mortgage insurance are really costs to obtain a new loan.
Prorated property taxes, insurance payments and rents are usually considered deductible
ongoing operating expenses and not part of the exchange. |
| Payment of appraisal fees, inspections, surveys and
environmental studies are also typically considered taxable boot if they are used to
obtain a new loan for the replacement property. If, however, the Purchase and Sale
Agreement for the replacement property was specifically made contingent upon the
satisfactory completion of these items, the Exchanger could argue that these expenditures
were really for the purchase of the property and not to obtain a new loan. |
| The Exchanger may wish to consider prorated property tax
payments or security deposits paid to the buyer of the relinquished property as the
equivalent of non-recourse debt from which the Exchanger was relieved. While this
treatment initially creates mortgage boot received, this payment can be netted against
liabilities assumed (mortgage boot paid) on the purchase of the replacement property. See
TAM 8328011 regarding prorated rent payments. |
| There is an issue as to whether the Intermediary's use of
exchange funds to pay for the costs and expenses to close on the replacement property
affect the safe harbor restrictions of Treas. Reg. 1.1031(k)-1(g)(6). The
Treasury Regulations are clear that normal costs of sale or purchase, including
commissions, fees and property taxes may be paid from the exchange proceeds and will not
be construed as constructive receipt of funds by the Exchanger. However, using exchange
proceeds for closing expenses unrelated to the direct purchase of the replacement property
must only be made at the time of closing the replacement property when the Qualified
Intermediary pays out all of the exchange funds it is holding in accordance with the
restrictions for completing the exchange set forth in 1.1031(k)-1(g)(6). |
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