Handling Closing Costs in a 1031 Exchange

A 1031 exchange rolls the gain from the sale of your old property over to your new property. To qualify for an exchange, both the old property you’re selling and the new property you’re buying have to be investment property, so oftentimes rental property is what’s being sold and/or bought in the exchange. When you’re dealing with investment property in a transaction, you’re effectively buying or selling two things: the property itself, and the rental business. The money you receive (if you’re selling) for these two items, or pay (if you’re buying) is handled differently for tax and 1031 exchange purposes. To get to the proper handling of each item on a settlement statement, it’s helpful if you think in terms of selling or buying the property versus buying or selling the rental business.

When you buy or sell the property, you’ll have expenses and income that are related specifically to the sale of that property. For example, there will be Realtor fees, title insurance, closing costs, etc. Because these costs relate specifically to the property, they are part of your 1031 exchange. For example: if you sell a rental property for a million dollars, you’ll have a real estate commission of about $60,000, and title insurance of several thousand dollars. Closing costs might run you another thousand, and you might also have transfer taxes of maybe $20,000 or $30,000 depending upon where the property is located. All of these costs arise solely as a result of the sale of the real estate, and as a result they relate directly to the 1031 exchange. If we assume that all of these costs total $100,000, then the net amount that will roll through your exchange will be $900,000.

Completely separate from the sale of the property is the sale of your “rental business” — if I can get you to think of it that way. You’re probably holding rent deposits for the tenants. Some may have paid their last month’s rent when they signed their lease and you’re holding that money as well. When I say “holding” I’m assuming that in a perfect world you have a separate account that contains those monies. In my experience however, real estate investors and landlords seldom have an actual separate account for these items.

...in a perfect world you would have a separate account that contains those monies...

When your buyer takes over, they will expect you to turn over those deposits and rent monies that you’re holding. If you close the sale of the property in the middle of the month, you will have already collected rent for the month and the buyer will expect you to pay them a prorated portion of those rents as well.

As you can see, there are a number of adjustments that arise as part of the sale that relate strictly to the actual rental of the property. These adjustments should ideally be kept separate from the proceeds and costs from the sale of the property itself. For this reason, we recommend that all the adjustments relating to the transfer of the rental operation be handled outside of closing in order to keep the flow of the 1031 exchange “pure,” if you will.

Of course, saying that the two components should be kept separate and the deposits and proration’s handled outside of closing assumes that you have a separate bank account that you keep the deposits in, and assumes that you have enough spare cash to cover the paying the prorated rents to the buyer. Since this is seldom the case the adjustments usually end up being part of the exchange. Let’s assume that all these prorations and adjustments total $50,000, and since you don’t have a separate account they will reduce your exchange proceeds by that amount. Technically this amount then becomes “boot,” meaning it’s taxable. In most cases, however, the amount that would be taxable boot is reduced, perhaps even to zero, by the tax deduction of these amounts. For example: if you reported the tenant deposits as income when you first received them, then you would deduct them for tax purposes when you turn them over to the new buyer. In this way the deduction offsets the boot income that is created when the adjustment flows through the settlement statement.

You will have similar types of adjustments when you buy the new property, and again it would be better if you keep the costs of purchasing the property separate from the costs of buying the rental business. For example, you’ll be receiving the tenant deposits and prorated rents from the seller.

It would be better if this were handled outside the purchase closing, but not doing so isn’t fatal to your exchange. If they are all mixed together, your tax accountant can sort them out for their proper recording. So don’t stress when your exchange intermediary recommends that your rental items be handled outside of closing.