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 Exchange Expenses
There are a number of closing costs that can be deemed to be “exchange expenses” which should be subtracted from the consideration received by the taxpayer, thereby reducing the realized gain on the transaction. They are: The taxpayer’s attorney’s fees, sales and transfer fees, shipping costs, bidding costs, accounting fees, survey costs, appraisal fees, recording fees, real estate commissions, application fees, engineering fees, title search fees, and Qualified Intermediary “services fees.”
Non-Deductible Exchange Expenses
There are a few items that are reflected on the final settlement statement which probably will not qualify as an “exchange expense”. They are prepayment penalties on mortgages or deeds of trust, property taxes, utility charges, interest on mortgages or deeds of trust, association fees, late fees, and insurance bills.
Some of these items, however, under different sections of the IRS Code may be deductible against taxable income as interest, taxes, or operating expenses.
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.
