While the long-term advantages of a 1031 exchange appear to be self-evident, the costs connected with completing the transaction must also be considered. Although the benefits often exceed the downsides, it is crucial to be aware of the intricacies when evaluating whether or not an exchange is suitable for you and your circumstances.
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What is a 1031 Exchange?
According to the Internal Revenue Service, a 1031 exchange is the deferral of capital gains taxes that happens when an investment property is sold and replaced with a like-kind property that meets specific requirements. Taxpayers can use the funds to purchase a new investment while at the same time shifting their tax liability to the newly purchased investment.
Evaluating the costs involved in a 1031 Exchange can be irritating and complicated. There are numerous fees, prices, and services charges associated with the administration of 1031 Exchange transactions that you must consider.
Qualified Intermediary Fees
Paying the Qualified Intermediary is one of the most significant expenses in a 1031 exchange. A third party, known as a QI, assists in transferring relinquished and replacement properties. During the exchange process, they are the titleholder and have control over the escrow account.
The cost of a QI varies, but it usually costs between $500 and $1,500. There will be additional expenses if there are numerous properties on either side of the transaction. Some impose a flat cost per exchange, while others may charge separate fees for the relinquished and new properties.
Keep in mind that costs are based on the level of risk exposure and the amount of work performed by the Qualified Intermediary. In large Forward 1031 Exchanges, along with the more involved Reverse 1031 Exchanges and Build-To-Suit 1031 Exchanges, the Qualified Intermediary must guarantee that they are adequately reimbursed based on the degree of risk exposure.
The Cost of Real Estate Transactions
At least two, and maybe more, real estate transactions will be involved in a 1031 exchange. If a QI is involved, the expenses for the sale and purchase of the properties are paid from the exchange proceeds. These funds are kept in an escrow account established by the taxpayer.
The costs of immediately buying or selling a property, or the cost of acquisition, are referred to as exchange expenditures. Some of these costs, known as non-exchange charges, are taxable, while others, known as exchange expenses, are not. Operating expenses and borrowing fees are examples of non-exchange expenses.
1031 Allowable Exchange Expenses
A typical 1031 exchange entails several expenses to complete the transaction. While closing costs paid out of the sales or 1031 exchange proceeds are an essential component of the exchange process, they may or may not result in a taxable event for the exchanger.
Some Other Things to Consider
Keep in mind that anything purchased using exchange funds later determined to be a cost of obtaining a new loan is deemed a non-exchange cost and subject to tax responsibility. The direct costs associated with obtaining the property, on the other hand, do not result in a taxable event.
Alternatively, consider the transaction as an all-cash transaction to get a different perspective. When paying with the proceeds of the exchange, anything that would not be included in an all-cash situation (for example, loan acquisition charges) would be subject to taxation. The same would apply to loan acquisition fees as well as anything else.