Permissible and Non-Permissible Closing Costs for 1031 Exchanges
A 1031 exchange allows real estate investors to defer capital gains taxes by reinvesting proceeds from the sale of a relinquished property into a like-kind replacement property. However, strict rules govern how exchange funds can be used. Understanding which closing costs are permissible, and which are not, ensures compliance and prevents unintended tax liabilities.
Permissible Closing Costs in a 1031 Exchange
The IRS permits certain transactional expenses to be paid with exchange funds without triggering a taxable event. These include costs that are considered normal and necessary to facilitate the sale or purchase of real estate. Examples include:
Broker Commissions – Real estate agent and broker fees associated with both the relinquished and replacement properties.
Title Insurance Premiums – The cost of title insurance policies required by lenders or customary in real estate transactions.
Escrow Fees – Charges for escrow services in handling the closing process.
Recording Fees – Fees associated with legally recording the property transfer.
Transfer Taxes – State or local transfer taxes directly related to the exchange transaction.
Legal and Closing Attorney Fees – Attorney costs directly related to completing the exchange transaction.
Non-Permissible Closing Costs in a 1031 Exchange
Some closing costs cannot be paid with exchange funds without triggering taxable boot—additional funds that do not qualify for tax deferral. These include expenses unrelated to the real estate transaction itself, such as:
Loan Costs and Financing Fees – Loan origination fees, points, underwriting fees, and prepaid interest cannot be covered using 1031 exchange proceeds.
Property Taxes and HOA Fees – Prorated property taxes, homeowners association fees, and other operational expenses.
Rent Prorations and Security Deposits – Payments or reimbursements related to leases or rental agreements.
Repair and Improvement Costs – Funds used for property repairs or renovations before closing are not considered permissible exchange expenses.
Due Diligence Costs – Inspection fees, environmental reports, and feasibility studies that are not a direct condition of closing.
Avoiding Taxable Boot and Best Practices
To maximize tax deferral, investors should structure the transaction carefully:
Ensure All Proceeds Are Reinvested – Any unused exchange funds or payments toward non-permissible costs can be considered taxable boot.
Use Separate Funds for Non-Qualified Costs – Pay for non-permissible expenses with personal funds or financing rather than exchange proceeds.
Work with a Qualified Intermediary (QI) – A QI can help allocate funds properly and ensure all costs align with IRS guidelines.
Proper handling of closing costs in a 1031 exchange is critical to preserving tax deferral benefits. While some expenses qualify, others— such as financing fees and prorated taxes — must be paid separately. Consulting a qualified intermediary and tax professional ensures compliance and maximizes the benefits of a 1031 exchange.
