Dealing with Possible ‘Boot’ Relating to 1031 Exchanges

The rules surrounding 1031 exchanges, or tax-deferred property transactions, can be confusing. If you have real estate assets that are eligible for 1031 exchanges, it is important to understand what closing costs and other expenses may be used to decrease realized or recognized gain in each transaction.

The primary reason for investing in property that qualifies under the IRS 1031 exchange program is to maintain and increase your equity position. It is, therefore, important to know what sorts of fees might not be allowable under current guidelines, and which expenses could be termed “boot,” or taxable gain to you.

If some of the costs are classified as boot, you might be obligated for payment of taxes on that boot. Since the purpose of the 1031 exchange is to defer taxes by eliminating current liability on individual transactions, you must pay strict attention to the types of expenses you incur on each exchange, and assure that, where possible, the expenses you claim fall under the commonly recognized guideline of allowable expenses.

In some cases, this is difficult because governing authorities are themselves unclear about authorized deductions and expenses. Commissions are clearly authorized. But, in addition to real estate brokerage commissions, most tax authorities consider the following items to be allowable:

  • Title insurance premiums
  • Exchange or accommodator fees
  • Finder’s fees
  • Testing and inspection fees
  • Notary and recording fees
  • Documentary transfer fees,
  • Escrow, processing and statement fees
  • Tax service fees
  • Messenger fees
  • Legal and accounting fees

These types of “exchange expenses,” although they are not specifically allowed by Revenue Ruling 72-456, are generally unquestioned.

It is important, however, in 1031 Exchange dealings, to have a qualified expert available to advise you in order to minimize the consequences of any expenses that might be classified as boot.

While boot is to be avoided in 1031 exchanges because of its implications for additional tax liability, it is not always necessary to entirely avoid questionable expenses or fees. Indeed that may not be possible. In some cases, however, such expenses may be deductible in other ways, specifically as operating expenses, taxes or interest, even though subject to the passive loss limitation.

Even security deposits, while commonly classified as boot if held in a separate account by a landlord, (or under other specific and defined conditions), can be left out of the closing if the borrower acquires a new property of equal or greater debt or brings sufficient new cash to closing.

The following is a list of closing costs that are commonly not allowable as exchange expenses, and might be classified as boot:

  • Security deposits (as stated previously)
  • Rents
  • Property taxes
  • Utilities
  • Insurance
  • Association dues
  • Ongoing repairs
  • Credits to buyers
  • Costs associated with the loan; including such items as application and processing fees, points, mortgage or title insurance, appraisals, loan-related expenses or fees, and inspection fees.

Selling expenses for a property to be relinquished under a 1031 Exchange also have an effect on the amount the exchanger must spend for a replacement property. In effect, you can sometimes treat the closing costs and expenses, whether allowable or not, as a sliding scale to balance the amount you must pay for replacement property under the program.

Your financial adviser or attorney is the best source of information for the details. These buying and selling expenses, often categorized as transactional items, can have an effect on your bottom line for any planned exchange, affecting not only your tax status, but also your equity holdings.

Peak 1031 Exchange is a leading provider of national 1031 exchange services. We have a fully-qualified team ready to advise you about any of the various types of exchanges, and we are knowledgeable about the various types of fees and expenses that might be classified as boot in relation to a planned property exchange.

Please contact us if you have questions or would like to discuss your entry into the 1031 Exchange program.

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