Avoid Costly Mistakes: Know Which 1031 Exchange Closing Expenses Are Taxable

If you’re navigating a 1031 Exchange, understanding which closing costs could trigger a taxable event is not just helpful—it’s critical to preserving the full value of your deferral.

Many investors incorrectly assume all closing costs are covered under the 1031 umbrella. While standard selling costs such as broker commissions, title insurance, and escrow fees are typically safe, certain expenses paid from exchange proceeds can unexpectedly generate a tax liability.

Here’s what you need to watch out for:

🚫 Operating & Financing Costs That Could Create a Taxable Event:

  • Prorated rents and security deposits

  • Property taxes and insurance

  • Repairs and maintenance

  • Loan-related fees (points, appraisals, lender’s title insurance, inspections)

✅ Fully Allowable 1031 Expenses:

  • Real estate broker commissions

  • Owner’s title insurance premiums

  • Attorney or CPA fees related to the transaction

  • Transfer tax and recording fees

Pro Tips to Protect Your Exchange:

  • Pay any prorated rents, security deposits, or utility bills outside of closing or hold them in escrow.

  • Offset non-qualifying expenses by treating them as debt relief when feasible.

  • Review the settlement statement with a tax advisor before closing—even small adjustments can prevent a taxable event.

Investors planning to roll proceeds into a replacement property should scrutinize every line item. An experienced Qualified Intermediary and a tax advisor can ensure compliance, protect your deferral, and keep more equity working for you in the next deal.

📌 Remember: Every 1031 Exchange scenario is unique. This content is educational, not legal or tax advice. Always consult with a licensed professional to verify how these guidelines apply to your transaction.

FAQ’s

1. “Can I still use 1031 proceeds to pay for property taxes and insurance if I reimburse the exchange later?”
No. Once 1031 exchange proceeds are used to pay non-qualifying expenses like property taxes or insurance at closing, a taxable event has occurred—even if you reimburse the exchange account later. These funds should be paid outside of closing or structured in a way that avoids direct use of exchange proceeds. Always coordinate with your Qualified Intermediary beforehand.

2. “How do I properly document non-recourse debt offsets to avoid triggering taxes on disallowed expenses?”
To offset taxable items through non-recourse debt relief, the debt you assume on the replacement property must exceed the debt paid off on the relinquished property. This needs to be clearly outlined in your closing documents and verified with your lender and Qualified Intermediary. A tax advisor can help ensure the treatment is defensible under IRS guidelines.

3. “What steps should I take to ensure my Qualified Intermediary and closing agent are aligned on allowable vs. unallowable expenses?”
Prior to closing, schedule a joint review of the draft settlement statement with both your Qualified Intermediary and your tax advisor. Clarify which line items are being paid from exchange proceeds and ensure that unallowable costs (e.g., prorated rents, loan fees) are excluded or paid from separate funds. This collaborative approach minimizes errors and helps preserve your tax deferral.