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Closing Costs/Boot

Everybody has costs to sell a property.  Even the government realizes that brokerage fees reduce the amount of equity available to buy a Replacement Property.  The following will explain how to look at closing costs.

TREASURY DECISIONS

IRC §1031(b) and (d) require a taxpayer to have equal or greater equity and equal or greater debt in their replacement property(s) to avoid “boot.” An exchangor can always offset mortgage “boot” or debt relief by adding more cash to the transaction but they cannot offset “cash boot” by increasing the mortgage.   The question is, what does the IRS consider equal or greater equity?  Generally, non-recurring closings costs are considered an expense that reduces the amount realized.  This allows a taxpayer to utilize exchange proceeds to pay them.  Such expenses should include all those expenses typically deducted by a seller in a taxable sale pursuant to IRC §1001, or capitalized by a buyer and added to a property’s basis under IRC §1012.  Unfortunately, the regulations do not specifically list all possible expenses and their acceptance by the IRS.  However, there are some guidelines which can be followed: 

1) Brokerage Fees
In Revenue Ruling 72-456, 1972-2 Cum Bull 468 and G.C.M. 34895 (June 5, 1972),theInternal Revenue Serviceallowed the deduction of brokerage commissions from exchange proceeds as they reduced the amount of equity the taxpayer realized and are added to the basis of the replacement property.  The effect of this ruling should not be limited only to brokerage commissions and can logically be applied to any non-recurring closing cost. 

2) Selling Expenses
IRS Letter Ruling 8328011 implies that all normal selling expenses, not just brokerage commissions, reduce recognized gain.  These deductions are treated as an expense incurred in the selling of a property.  They are also considered a cost in the purchase of the replacement property.  It is for this reason the Internal Revenue Service requires that only the net equity be transferred to the replacement property(s).  (Note:  Costs which don’t qualify as costs of sale for exchange purposes may still be deductible as current year expenses in the operation of the property.)

The following is a list of what should, what might, and what won’t qualify as an expense that can be paid from exchange proceeds:

*The Internal Revenue Service considers mortgage points paid to acquire a loan for the replacement property prepaid interest and nondeductible from exchange proceeds.  Other costs related to obtaining a loan should likewise be left out of the exchange and paid directly by the taxpayer to avoid potential tax boot.

PROPERTY INSPECTIONS
A conflict could arise when a lender requires certain inspections as part of their loan commitment.  This could result in hazardous waste and property inspection costs to be categorized as a lender requirement causing them to be nondeductible.  One possible solution is to transfer this responsibility to a contractual obligation as a condition of acquisition under the purchase and sale agreement.

REPAIRS VERSUS IMPROVEMENTS

1) Repairs Defined   

A repair keeps your property in good operating condition.  It does not materially add to the value of your property or substantially prolong its life.Repainting your property inside or out, fixing gutters or floors, fixing leaks, plastering, and replacing broken windows are examples of repairs.¹   Repairs made in connection with an overall remodeling project must be capitalized.² 

You can deduct the cost of repairs that you make to property held in connection with a trade or business or for the production of income provided they do not materially add to the value of the property nor appreciably prolong its life.⁴  Repairs can be expensed in the year in which they are made and written off against income earned from the business activity. Residential rental property or commercial or industrial buildings are examples of real estate which qualify for such deductions. 

2) Improvements Defined  

An improvement adds to the value of property, prolongs its useful life, or adapts it to new uses.³   The capitalized cost can generally be depreciated as if the improvement were separate property using the property’s current depreciation schedule under IRC §168⁽ⁱ⁾⁽⁶⁾ .

You cannot deduct the cost of improvements. ⁵  Improvements must be capitalized and added to the basis of the property to which they are made.  You recover the cost of improvements by taking depreciation over a prescribed period of time. ⁶

Examples of Improvements:

Room Additions, Bedroom, Bathroom, Deck, Garage, Porch, Patio, Plumbing, Septic system, Water heater, Soft water system, Filtration system, Lawns & Grounds, Landscaping, Driveway, Walkway, Fence, Retaining wall, Sprinkler system, Swimming pool, Heating & Air Conditioning, Heating system, Central air conditioning, Furnace, Duct work, Central humidifier

Interior Improvements, Built-in appliances, Kitchen modernization, Flooring, Wall-to-wall carpeting, Miscellaneous, Storm windows, doors, New roof, Central vacuum, Wiring upgrades, Satellite dish, Security system

OTHER EXPENSES

Other expenses you can deduct from your gross rental income include advertising, janitor and maid service, utilities, fire and liability insurance, taxes, interest, commissions for the collection of rent, ordinary and necessary travel and transportation.⁷  Section-1 termite work is generally considered a repair and can be expensed against exchange proceeds.

RELATIONSHIP WITH AN IRC §1031 TAX DEFERRED EXCHANGE

When using exchange proceeds to pay for repairs made to the relinquished property prior to sale, the ability to offset the recognized “boot” with the repair expense will minimize the resultant tax impact.  However, exchange proceeds used to pay for a capital improvement such as a new roof will cause “boot” to be recognized without an offsetting expense.  In this instance, it is best to pay for improvements with separate funds.

 ¹  IRS Publication 527 (1998).

 ²  Treas. Reg.1.162-4.

 ³  IRS Pub. 527 supra.

 ⁴  Treasury Regulation Section 1.162-4, Internal Revenue Code Section 212(2).

 ⁵  Internal Revenue Section 263.

 ⁶  Internal Revenue Code Section 168.

 ⁷  IRS Pub. 527 supra.