When closing on the sale of a property, you will likely incur a variety of expenses, and you may find yourself wondering what is and isn’t acceptable to debit off your closing statement. This is particularly important when you are making a 1031 exchange.
Any proceeds or cash benefits you receive from a 1031 transaction are known as boot. Boot is not part of a like-kind exchange, and is therefore considered taxable.Closing on a sale will always carry associated costs such as agents’ commissions and deed recording fees. It is acceptable to debit these off on your closing statement, because they do not represent any extra cash benefits for you. Expenses such as prorated rent and security deposits that must be transferred to the new owner are another story.
The correct way to deal with these is to write the owner a check from your own operating account. Debiting these expenses to your closing statement would result in a cash benefit in that money in your operating account would be freed for your use, and this money is considered to be boot.
You should be equally wary when you are closing on the your replacement property, especially in regard to fees related to the acquisition of new debt. Just as expenses such as security deposits and rent proration on the sale of your old property must come out of your own pocket, so must loan origination, underwriting and processing fees.
The message you should take away from this article is that it is best to simply pay these kinds of expenses out of your own account rather than making a risky attempt to walk out of a 1031 exchange with extra cash in your pocket. The IRS has pursued litigation against investors who have tried these kinds of tactics, one notable example being the case of the Commissioner v. Garcia.
U.S. investors can save big money by using a 1031 exchange to defer all of their capital gains tax on the sale of investment property. A 1031 tax exchange is almost like getting an interest free loan from Uncle Sam!
