In an exchange, there are two categories of expenses: exchange expenses and non-exchange expenses. Click here to see an example of closing costs as Exchange or non-Exchange costs. 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.