Closing Costs in a 1031 Exchange: Advisor Reference Guide

Why Closing Costs Matter in an Exchange

Closing costs in a 1031 exchange are not neutral. The treatment of each cost affects whether boot is created, how basis is computed, and ultimately the tax benefit of the exchange. A cost that is perfectly normal in a standard real estate transaction may trigger boot or other adverse consequences in an exchange if it is paid from exchange proceeds or allocated incorrectly.

Your role: review costs before closing, coordinate with the QI and title company, and ensure costs are allocated correctly.

The Core Distinction

Exchange-related costs can be paid from exchange proceeds without creating boot. These are costs directly tied to acquiring the replacement property.

Non-exchange-related costs may create boot if paid from exchange proceeds because they represent cash or value beyond the acquisition itself.

Closing Cost Reference Table

Repair Credits and Concessions: Decision Tree

How a seller concession is documented on the settlement statement determines the tax consequence.

Best practice: Negotiate the purchase agreement to reduce the purchase price by any seller concession. Have the purchase agreement state the net price. At closing, the deed and settlement statement should show the net purchase price only.

Settlement Statement Review Checklist

Review the preliminary ALTA settlement statement at least five business days before closing.

Sale of Relinquished Property Section

• Sale price is correct
• Real estate commissions are deducted
• Existing mortgage/liens are paid off
• Net proceeds are directed to the QI (not to the taxpayer)

Purchase of Replacement Property Section

• Purchase price is correct
• Each cost is categorized as exchange-related or financing-related (use the table above)
• No non-exchange-related costs are being paid from exchange proceeds
• Prorations are adjustments only (no boot created)

Financing Section

• Loan amount is correct
• Lender fees are paid by lender or borrower (not from exchange proceeds)
• Net loan proceeds are documented

Sample Instructions to Title Company

Send written instructions to escrow before closing:

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INSTRUCTIONS REGARDING EXCHANGE CLOSING COSTS

To: [Title Company Name] Escrow Department Re: 1031 Exchange Closing Instructions - [Taxpayer Name] Date: [Today]

1. Exchange costs paid from proceeds: QI fee, exchange counsel legal fees, title insurance (owner's policy), recording fees, transfer taxes, title examination, deed preparation, escrow fees.

2. Financing costs NOT paid from proceeds: Lender origination fee, discount points, lender appraisal, lender inspection, underwriting fees. These are paid by the borrower or lender separately.

3. Buyer's due diligence costs NOT paid from proceeds: Inspection, appraisal, environmental review ordered by buyer. Buyer pays directly.

4. Repair credits: Reflected as a reduction to purchase price, not as a separate payment to buyer.

5. Prorations: Property taxes, HOA dues, and utilities are settlement adjustments; no separate costs.

If any cost or allocation is unclear, contact the undersigned or the QI before closing.

QI: [Name and contact] Advisor: [Name and contact]

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Send a copy to the QI, the buyer's lender, and the title company. Confirm receipt.

QI Coordination

Provide the preliminary settlement statement to the QI at least five business days before closing. Ask:

1. Are you comfortable with the costs and allocations shown?
2. Which costs will you pay from exchange proceeds?
3. Are there any costs you flag as potentially problematic?
4. Should I instruct the title company to allocate any costs differently?

Common Scenarios

Boot Calculation and Closing Costs

Closing costs paid from exchange proceeds do not create boot if they are legitimate acquisition costs. Closing costs paid from non-exchange funds also do not create boot. Boot is triggered when the taxpayer receives cash or debt relief as part of the exchange.

Documentation for Audit Defense

Preserve:

• Preliminary settlement statement
• Final settlement statement
• Written instructions to title company and QI
• QI confirmation of cost allocation
• Communications about disputed costs

Clear documentation of how costs were allocated and why supports the taxpayer's position in an audit.

Bottom Line

Closing costs are tax-sensitive in an exchange. Not all costs can be paid from proceeds without consequences. Review the preliminary settlement statement early, categorize costs using the reference table, coordinate with the QI and title company, and document everything. An hour of review before closing beats days of explaining boot after closing.