Knowing Your 1031 Exchange Tax Deductions
November 28, 2016
By Guest Author Chris Miller
We all know that expenses are deductions from income tax. For example; if I buy a “widget” for $500,000 and sell it for $1,000,000, I won’t owe the IRS taxes on that $1 million, just on $500,000 ($1,000,000 gross proceeds – $500,000 cost = $500,000 taxable profit). However, many investors don’t know that similar “expense” tax deductions can apply to their 1031 exchange.
Recently a client of mine was under the impression that because he sold a property for $1 million, he needed to buy a $1 million replacement property. This was a problem because he only received $925,000 “net” after selling expenses (real estate commission, closing costs, etc.). After re-paying his $500,000 loan, he was left with $425,000 in his accommodator’s account.
My client thought that he still needed to buy $1 million of replacement property and needed to assume a larger loan to cover the shortfall caused by those expenses. I told him about the deductions created by selling expenses, and he asked me to provide documentation of this. To my surprise, this documentation was tough to find. IRS publications would require reading and digesting thousands of words, and most of the accommodator websites that I checked seemed to ignore these deductions. I doubt the accommodators omitted this fact out of ignorance. Rather, in an attempt to simplify their examples, they simply created hypotheticals that assumed “no transaction costs.” A practice I admit doing myself in writing many of my own articles
Below we will explore what is deductible, what is not related to the exchange, and what expenses aren’t taxable in a 1031 exchange.
1031 Exchange Expenses that are Tax Deductions
Any expenses that are directly related to the sales transaction are 1031 exchange tax deductions. This includes items such as:
- Real estate broker commission costs
- Accommodator fees
- Escrow and title insurance fees and filing fees1
- Transfer taxes (if applicable in the property’s location)2
Note that although you may have completed the work in order to achieve a better sales price, or even during escrow as part of the sales process, maintenance work such as painting would not be deductible from your 1031 exchange. This work is deductible – but from your operating income. Uncle Sam doesn’t want you to write that off as part of your exchange; he wants you to write it off from your income. I’ll expand on this in a little more depth below.
Other Expenses that are Tax Deductible – But not from your 1031 Exchange
Similar to the example above, there are some expenses that are deductible – just not from your 1031 exchange. This includes credits to the seller such as:
- Prorated property taxes
- Prorated rents
- Security deposits.3
Property taxes are an ordinary expense that are deducted from your income for tax purposes. Similarly, the prorated property taxes that you paid up to the day you sold the property are just ordinary expenses. Prorated rents and return of security deposits are a deduction from income in the form of income you received that really wasn’t yours. That tax obligation is passed on to the new owner and removed from your income as a deduction.
Related post: Finding a Qualified Intermediary
Some Sales Proceeds Are Not Taxable
The good news is that some of your sales proceeds may not be taxable because you have already paid taxes on them. Such proceeds include things like reserves funded from rents that are held by the lender or by your property/asset manager.
Many lenders may require that you fund a reserve account from your income every month, and may require you to make a monthly or annual payment in addition to your mortgage payment that funds this account, which they hold for you. This works the same way as property tax and insurance impounds do in residential loans (except that in commercial loans, they wouldn’t be optional). A commercial lender may want to hold these reserves for a future roof replacement or similar project that will maintain the value of their collateral. Similarly, many property or asset managers will ask their clients to contribute the property’s income to a reserve account they control. These funds are usually kept on hand to address emergency repairs or minor repairs that can be done without waiting for your approval.
Both outlays cited above aren’t taxable today because they were taxable in the past as income. In much the same way that your principal payments on a loan aren’t a tax deduction (since you are using the money to pay down a debt), contributions to reserves aren’t deductions in the year they are made. They are, instead, taxed as a form of “phantom income” – a term used to describe income that you paid tax on, but didn’t get (yet) to put into your pocket.
Are you in search of a 1031 Exchange replacement property? We have dozens of institutional-grade 1031 Exchange properties to choose from. Sign up for a free account to view our current inventory.
Chris Miller is a Registered Representative with SANDLAPPER Securities, LLC. He can be contacted at firstname.lastname@example.org.
Please note: 1031RPS.com and its associated personnel are not tax professionals, and they recommend investors consult with their tax advisor to ensure their 1031 Exchange is within the IRS guidelines established.
1 http://www.exeter1031.com/permissible_1031_exchange_closing_costs.aspx . Accessed June 30, 2016.