Closing Costs and the Tax Deferred Exchange
The internal revenue code does not have many regulations about 1031 exchange costs. How to handle such expenses and costs remains unclear. For instance, despite the general rule involving the exchange of relinquished property and replacement property, it is unknown whether the exchanger has to deal with a taxable boot on the exchange funds.
How much does a 1031 exchange cost?
A direct cost that exchangers incur when using 1031 exchange goes to the qualified intermediary (QI). Such fees differ, but reports usually indicate the typical 1031 delay is between $650 and $1200. The exchanger may also incur additional operating expenses. A QI may also offer an overnight delivery charge for documents that need a fast response. That only happens with a simple deferred exchange. Complex ones can be more expensive.
Qualified intermediary fees
The role of a qualified intermediary
According to IRS regulations, 1031 exchanges must include a third party. That is where the services of a qualified intermediary become mandatory. They transfer the relinquished property to the buyer and hold on to the funds until the exchanger finds a replacement property. They are also responsible for acquiring the new property and transferring it to the taxpayer. In short, they facilitate transactions during the exchange process.
How much does an intermediary cost for a 1031 exchange?
Third parties play a significant role in every 1031 exchange. That is why they can get up to two-thirds of the exchange costs and interests.
Delayed exchange costs
Qualified intermediaries can be non-institutional or institutional. The former are independent companies that do not have affiliations with title companies, while the latter do.
Non- institutional intermediaries are slightly cheaper, with the average 1031 exchange costs ranging between $600 and $800. Their institutional counterparts cost from $800 to $1200.
The qualified intermediary fees in the delayed exchange cover administrative, accommodation, and qualifying fees, such as document preparation, processing costs, notary, and other additional fees.
Other costs you may also incur include additional property fee that ranges from $300 to $400 and opportunity cost that applies when the IQ keeps the interest on the escrowed funds. Interest income mainly applies when the exchange proceeds from the relinquished property remain in the escrow account for more than 180 days before closing on the replacement property.
Reverse exchange fees
Reverse 1031 exchange, also known as construction 1031 exchange, costs more. The exchange structure means buying the replacement property before completing the sale of the relinquished property or closing statements. The process is more complicated because most investment properties are available where demand exceeds supply.
Since there is no significant interest income when dealing with a reverse exchange, qualified intermediary’s fees are higher – between $3000 and $8000. You save on foregone accrued interest but spend more directly out of pocket.
Interest income: How a qualified intermediary makes most of their money
The most significant 1031 exchange expense that taxpayers incur directly is the setup cost, which is 1/3 of the total qualified intermediary fees. The rest of the exchange expenses are interest-based. The QI holds the exchange proceeds from the first property until the purchase finalization of the investment property. During that time, the net proceeds can be gaining interest in money market setups or other deposit account types. All that money goes to the QI.
You have 180 days to finalize the purchase contract of the second property after completing the sale contract of the first. The interest money can accumulate to a lumpsum amount.
1031 Exchange Cost – 1031 Exchange transactional costs
1031 Exchange generally includes various expenses necessary for making exchanges possible. Although these expenses are essential parts of an exchange transaction, certain costs paid from sales, 1031 exchange proceeds may or may not cause tax consequences for an exchange.
Are there closing costs on a 1031 exchange?
Closing costs are available in every 1031 exchange – the only difference is whether they lead to a taxable event. According to the internal revenue service, non-transactional costs in the 1031 exchange do not count as expenses. Regulations surrounding other non-exchange expenses remain ambiguous, meaning real estate investors should be cautious dealing with them and distinguish when to cover some of those costs out of pocket.
Here are some typical allowable closing costs in 1031 exchanges compared with cost attribution metrics:
Allowable closing costs
Appraisal fees for purchase contract: Appraisal fees range from $5000 to $10000 depending on whether it is a large office building or an average-sized one. The costs differ from the charges by mortgage lenders.
Escrow fees: The escrow fee differs depending on available additional fee requirements. You may pay between one and two percent of the sale price.
Tax advisor and attorney fees: Tax advisors and attorneys are responsible for ensuring you remain protected throughout the 1031 exchange process. They set up the swap and monitor the post-exchange process to ensure you do not encounter legal issues. They charge a flat fee that can be more than $100,000.
Title insurance: Title insurance premiums, title company fees, document preparation costs, title closing fees, and deed recording can cost 1% of the property sale price.
Real estate broker commissions: Broker commissions are not flat fees. The amount varies with the size, type, and location of the property. Exchangers can spend 5% to 6% of the final cost of investment property, with the amount shared between seller and buyer agents.
Inspection fees: Most inspectors charge $0.1 per sq. ft., but that can change with the property state.
Transfer taxes: Transfer taxes are a portion of the value of the exchange funds. You can calculate the amount during property closing, but the average is 1% to 3% of the total value.
Recording fees: It costs approximately $200 to record 1031 exchange. That amount can be higher if recording fees include transfer taxes. It can also be a flat fee or a percentage of the new loan when considered mortgage registration tax.
Loan fees for replacement property: Real estate professionals can acquire replacement property through a loan and pay origination fees and similar costs. Net proceeds of the loan can cover those charges to pay for notary, lender attorney costs, and document preparation.
Pro-rated taxes: Property sellers are responsible for pro-rated property tax payments. Proration is according to the days before closing. The amount can be up to 110% of the real estate taxes.
Closing costs likely to result in a taxable event
Other closing costs can lead to a taxable event. Examples include application fees, mortgage lender appraisals, property taxes, pro-rated rents, lender title insurance, maintenance and repair charges, lender’s title insurance, and many others. Consulting a tax advisor prior to the closing can help you get a reprieve through the tax-deferred exchange. You can also try other measures such as paying the amounts for such charges in a qualified escrow account with the sale closing agent. Security deposits, prorated property tax payments, and accrued interest can be non-recourse debt.
How are non-qualified exchange expenses treated?
Non-qualified expenses are capital gains with a different tax basis. You can clear them before the closing to avoid paying more cash on tax liability. Even so, you can still spend some money out-of-pocket during purchase and sale contract closing, depending on the constructive receipt date.
Expect higher fees for non-standard 1031 exchanges
Non-standard exchanges like those involving multiple properties are more complicated. They differ from tax-deferred 1031 exchanges, making qualified intermediary’s use more crucial in such processes. Those factors increase the fees by exchange accommodators.
Is 1031 Exchange Fee Tax Deductible?
Many 1031 exchange fees are tax-deductible. For instance, title closing fees and broker commissions eliminate tax liability.
When is a similar exchange worth the cost?
According to the tax court, a like-kind exchange may be worth the cost if the property owner has owned it for several years and has equity in its sale. A deduction on capital gains tax is typically much higher than costs to complete 1031 exchanges for taxable income. You can use the gain realized as a purchase price for another property.
Closing Point: Always ask for a full breakdown of costs before engaging in a 1031 Exchange, as costs can differ from one QI to another.