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Do Real Estate Investors Pay Closing Expenses On 1031 Exchanges?

Sep 15, 2008
The general rule when it comes to 1031 exchanges is that all proceeds from the sale must be reinvested in the replacement property, but as a property investor you likely have experience with the other costs associated with closing on a sale, including your real estate agent's commission, the recording of the deed, and know that some of your proceeds must be put towards these sorts of transactional expenses.

But what about expenses that don't necessarily fit into your typical closing statement, a classic example of which being rent proration and security deposits on the sale of a relinquished property?

The correct way to go about transferring future rent and security deposits to the new owner of the property is to cut a check from your own expense account. If you debit these kinds of expenses to your closings statement, you are effectively freeing money in your account for your own use and taking what as known as boot from the proceeds of the transaction. Any cash benefit or boot you receive from the sale is not considered part of a like-kind exchange, and investors who have attempted this have found themselves facing IRS litigation.

Section 1031 operates under the assumption that the investor is transferring the entirety of the equity on the sale property to the replacement. It is unacceptable to debit expenses such as rent proration or security deposits to the closing statement as that frees money in your operating account for your use. Any cash benefits or proceeds that you receive in this context are referred to as boot, and because they are not part of a like-kind exchange are taxable.

In the real estate business, it is always advisable to take care when dealing with the variety of expenses that arise during a closing, and this is doubly important when making 1031 transactions. Section 1031 is based on the idea of a like-kind exchange, in which you move everything from point A to point B without skimming any kind of cash benefits or proceeds off the top, so it is best to avoid debiting expenses in a way that usurps this premise.
About the Author
U.S. investors can save a lot of money by utilizing a 1031 exchange to defer all of their capital gains tax on the sale of investment property. A 1031 tax exchange is almost like getting an interest free loan from Uncle Sam!
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