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.
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:
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.
REPAIRS VERSUS IMPROVEMENTS
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 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.
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.