As the timing on your 1031 exchange becomes imminent, tax advice and exchange expertise are recommended to avoid missing important deadlines and violating IRS guidelines to complete a successful tax-deferred exchange. This article will touch on three related topics concerning the 1031 exchange. First, it will provide a basic understanding of closing statements. Second, it will demonstrate how to calculate the amount required to avoid tax liability. Third, it will explain the 200% rule based on clarifications regarding the first two topics.
Closing Statements: What Does and Does Not Qualify as an Expense or a Cost for Your 1031 Exchange?
When it comes to closing statements, particularly where expenses are concerned, professional guidance is especially useful since the IRS has not published a complete list of qualified non-taxable expenses—and interpretation may vary between CPAs. One of the goals of this article is to clarify which transaction costs will be subsidized by the exchange and which others could be deemed boot if they are not offset in the transaction.
The exchange code stipulates that the net proceeds of the sale from the relinquished property will be taxable if not fully reinvested. As simple as this concept seems, varied costs could trigger some tax liability if processed incorrectly. For more-detailed information, you may click this link to the IRS Fact Sheet on Like-Kind Exchanges under IRS Code Section 1031.
We can simplify our approach by separating items in the closing statement into two categories: expenses and costs.
Here we will define expenses as any items related to owning a rental property. This is notable because expenses could offset capital gains when the relinquished property is sold. Generally speaking, these expenses belong in the Schedule E section on a tax return. Expenses, based on this explanation, include the following:
- Prorated rents
- Financing fees
- Property taxes
- Maintenance costs
Costs, on the other hand, will include any items directly related to selling said property. The first generally acknowledged cost that can be deducted from the replacement liability is the real estate broker’s commissions and referrals fees. We can also deduct from the sales price other transactional costs listed below:
- Qualified intermediary costs
- Title insurance
- Tax advisor fees
- Escrow agents or attorneys
- Escrow fees
- Filing fees
- Transfer taxes
Be aware of money spent that might not easily fit into either of these two categories. Furthermore, be prepared to do a little more digging into the closing statement to be able to properly categorize these line items. In a recent transaction, I had a client come across an item labeled “Bankruptcy Liquidating Trust” in a closing statement. In order to determine how exactly this should be labeled in the transaction, we had to analyze the item and label it according to its relation to the sale (cost) or the rental property (expense). In this case, “Bankruptcy Liquidating Trust” turned out to be a disposition fee, and thus it qualified as a cost of the sale. If doubts still stand, a CPA or escrow company may be able to clarify or help further analyze the item.
When analyzing your closing statement, two facts are important to consider. First, the costs of selling your property will reduce the net sales price, which will determine the amount required to be replaced in the 1031 exchange. The more in costs you can document, the easier it will be to find a replacement property that will meet your needs. Furthermore, reducing your net sales price reduces your capital gain. Since your basis in the replacement property will be determined by the purchase price less the gain deferred in the exchange, the more you can document, the higher your new basis will be. This will give you that much more in potential depreciation to take and that much less in recognizable gain if and when you ever realize that gain in a taxable sale down the road.
Second, the expenses related to owning the property will offset capital gains, decreasing your tax exposure when you finally cash out. Furthermore, any cash that ends up in the seller’s hands rather than going through a qualified intermediary will be considered boot. If you took money out to pay expenses that you did not document on your closing statement, you will be taxed on it.
How Closing Statements Relate to 1031 Identification Rule Limits
There are three possible identification rules for an exchange: the three-property rule, the 200% rule, and the 95% rule. Understanding the details of a closing statement is essential to completing a successful 1031 exchange when using the 200% identification rule because the 200% rule involves a number of important numerical limits that must be met that relate to the net proceeds of the property sold. We will focus on how to determine the limits on the 200% rule.
The first aspect of this rule allows the identification of an unlimited number of replacement properties so long as the total dollar value of what is being acquired does not exceed 200% of the sales price of the property sold. A common misunderstanding regarding this rule is that one must double the net proceeds (gross sales price – costs = net proceeds) to reach the 200% limit amount. In actuality, to determine the 200% identification value, one will advantageously double the gross sales price of the relinquished property to define the upper limit of the total value of the properties that you can identify.
By following this rule the correct way, one will be able to identify an unlimited number of replacement properties whose aggregate worth does not exceed 200% of the gross sales price, while being required to utilize only 100% of the net proceeds to comply with the 1031 exchange and avoid boot. In most transactions, depending on the amount of leverage on the property that was sold, this means that an investor essentially gets to double the number of options for reinvestment, typically providing much greater flexibility than what the three-property or 95% identification rules provide.
There are dozens of line items that find their way onto the average closing statement. In order to maximize the usefulness of a closing statement, one must identify expenses and costs in order to determine their true 1031 requirement and net equity proceeds. Expenses will offset capital gains. Costs aid in determining the net proceeds, which will be used to find the required amount to be replaced in a 1031 exchange. In addition, doubling the gross sales price stated in the closing statement will establish the limit for the 200% identification rule. Once you have these parameters in mind, you are better prepared to complete a successful 1031 exchange.