Closing costs refer to the fees and expenses incurred during the transfer of property ownership from a seller to a buyer. They are paid at the closing of the real estate transaction. However, they are specifically significant in a 1031 exchange because only certain types of closing costs can be paid with the exchange funds without resulting in a taxable event.
The 1031 exchange, also known as a like-kind exchange, is a mechanism in the United States federal tax code that allows investors to defer paying capital gains taxes on an investment property when it is sold, as long as another “like-kind property” is purchased with the profit gained by the sale of the first property.
The Internal Revenue Service (IRS) has guidelines on which closing costs can be covered in a 1031 exchange. Typically acceptable closing costs may include:
- Brokerage commissions
- Legal fees for services directly related to the exchange
- Escrow or closing agent fees
- Title insurance premiums
- Transfer taxes and recording fees
- 1031 exchange facilitator or intermediary fees
Conversely, some types of closing costs are considered “exchange expenses” and may not be paid from exchange funds without potential tax consequences. These may include:
- Financing fees or points related to a new loan
- Property taxes
- Insurance premiums
- Homeowner association fees
- Other property-related expenses that are not directly related to the closing
The exact definition of what constitutes “closing costs” can vary and taxpayers should seek advice from a tax professional or legal advisor to ensure their 1031 exchange complies with all IRS regulations and guidelines.