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TREATMENT
OF
CLOSING
COSTS
In an exchange, there are two
categories of expenses: exchange expenses and
non-exchange expenses. Exchange expenses include expenses that are typically:
■ deducted by the seller from the
gross sales proceeds in a taxable sale;
■ non-deductible by a buyer but capitalized and added to
the basis of property acquired;
■ costs specifically related to an exchange such as
intermediary fees and other exchange
transaction
expenses.
Typical exchange expenses include real estate
commissions, finder’s fees, owner’s title insurance
premiums, escrow fees, legal fees, intermediary fees,
and recording fees for the deed.
Some transaction expenses are non-exchange expenses and
include pre-paid mortgage interest, property taxes,
utility charges, owner association fees, and liability
insurance expense. If non-exchange expenses are paid out
of exchange proceeds, the exchanger will have taxable
income in the amount of the payments.
Security deposits and prepaid rent are also non-exchange
expenses. When selling the relinquished property, if the
exchanger reimburses the buyer for these items
outside of closing, this payment does not cause
taxable boot to the exchanger. However, if the buyer of
the relinquished property receives a credit on the
closing statement against the purchase price and the
exchanger-seller receives a corresponding debit, the
exchanger-seller will have taxable boot because the
exchanger now has the security deposits and prepaid rent
in his possession free of any obligation to a third
party and has, in effect, liquidated part of his equity
in the relinquished property. To
maximize tax deferral for the exchanger, these expenses
should be paid outside closing.
Loan origination fees, loan discount fees, loan buy-down
fees, loan application fees, appraisal fees (for
appraisals required by a lender), mortgage insurance
fees, mortgagee title insurance fees, credit report
fees, lender inspection fees, tax service fees (if
required by a lender), legal expenses for lender
documents, and any other loan related fees are also
non-exchange expenses. These expenses are treated as the
cost of obtaining a loan, rather than as a cost
associated with buying property and as such must be
amortized over the life of the loan obtained. Typically,
loan costs, for tax accounting purposes, are added to
the principal balance of the loan obtained to acquire
replacement property. Thus they reduce the equity in the
replacement property and may cause taxable income to the
exchanger.
Tax and insurance reserves are also non-exchange
expenses. If loan or exchange proceeds are used to pay
reserves, this will result in taxable boot to the
exchanger.
Any additional funds paid by an exchanger in excess of
exchange proceeds towards the purchase of replacement
property will be treated as cash boot paid by the
exchanger and will reduce the taxable boot resulting from
payment of loan costs and other non-exchange expenses
from exchange proceeds.
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