The Nuances of Section 1031 Exchanges (Part Three in a Series)

• August 18, 2021
• Carey M. Heyman, CPA

In the previous installments of our series highlighting the nuances of Section 1031 exchanges, we discussed the identification of replacement properties, the difference between a realized gain and a recognized gain and the concept of “boot.” In part three, we will cover transactional costs, otherwise known as “exchange expenses.”

Exchange expenses are defined on IRS Form 8824 as costs “paid out in connection with the exchange.” Unfortunately, that is it; there is no other substantial authority on the subject. Section 263 of the Internal Revenue Code (IRC) Regulations lists “transaction costs” that are to be capitalized into the basis of acquired property, as compared to as a deduction as a business expense. These costs reduce the realized and recognized gain from the disposition of the property, in the same manner that an exchange expenses would reduce the gain.

You may find the following exchange expenses on a closing statement:

• Broker’s commissions
• Legal and accounting fees in connection with the sale of the relinquished property or acquisition of the replacement properties
• Qualified intermediary and exchange accommodation titleholder (for reverse Section 1031 exchanges) fees
• Property appraisal fees
• Recording fees
• Title insurance
• Sales and transfer taxes

These costs are used to reduce recognized gain or are added to the basis of the replacement property.

Other line items that might appear on a closing statement that are not considered exchange expenses include mortgage interest, prepayment penalties / defeasance fees, property taxes, property insurance premiums and loan costs. These costs do not reduce the amount realized or recognized and are not added to the basis of the replacement property.

When it comes to Section 1031 exchanges and exchange expenses, taxpayers need to be careful with the concept of constructive receipt. The taxpayer may not, either directly or indirectly, receive or have control over any transactional proceeds. Costs that are typically not shown as paid on a closing statement or costs that are unrelated to the sale of the relinquished property or the purchase of the replacement property, may trigger a constructive receipt issue if Section 1031 exchange funds are used to pay for them.

Several safe harbors were established by the IRS for the purposes of determining actual or constructive receipt of money or other property for Section 1031 exchanges. While there is no statutory authority for the adoption of the safe harbors, it appears that as long as the transaction is structured within the safe harbors, the IRS will not challenge the Section 1031 exchange on the basis of constructive receipt. Again, lots of potential pitfalls with Section 1031 exchanges, but we’re here to help!

Source: IRS.gov

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