Qualified vs. Unqualified Closing Costs in a 1031 Exchange: What Every Investor Must Know

🚦 What Are Qualified Closing Costs?

Qualified closing costs are expenses the IRS allows to be deducted from your sale proceeds without jeopardizing your 1031 tax deferral. These costs are directly tied to the transaction and include:

  • Title insurance fees

  • Escrow fees

  • Recording fees

  • Broker commissions

  • Transfer taxes

  • Legal or tax advisory fees related to the exchange

These costs are safe and do not create taxable boot (a gain recognized during the exchange).

Pro Tip: Ensure the invoice or settlement statement clearly labels these fees to avoid IRS scrutiny.

⚠️ What Are Unqualified Closing Costs?

Unqualified closing costs are personal, financing, or non-transactional in nature. If paid with exchange proceeds, they can create boot, triggering capital gains tax. These include:

  • Prorated property taxes

  • Utilities or rent credits

  • Homeowners association (HOA) dues

  • Loan acquisition fees

  • Lender-related costs (appraisals, loan points, etc.)

  • Environmental reports or inspections

Always fund these costs with personal funds, not exchange dollars.

đź’° How to Protect Your Exchange

  • Use Exchange Funds Only for Qualified Expenses

  • Pre-pay Unqualified Costs with Personal Funds

  • Review the ALTA/HUD-1 Statement in Advance

  • Involve Your QI and CPA Early

📉 Case Example: Accidental Boot

You’re selling a property for $2M through a 1031 exchange. The closing costs total $100K, but $10K is for lender fees and prorated taxes. If you pay all $100K from exchange funds, $10K becomes boot and may be taxable—potentially costing thousands in avoidable taxes.

âś… IRS-Friendly Language for Closing Statements

Qualified Expense Label As
Escrow fees “Escrow or closing fee”
Title insurance “Title insurance premium”
Legal fees “Exchange-related legal fee”
Commissions “Broker commission”

Avoid vague or overly general terms like “adjustments” or “misc. services.”

🧠 Final Thoughts

Many investors spend weeks identifying the right replacement property but overlook the final details of the closing statement. That’s where unintentional tax exposure creeps in. Always treat your settlement sheet with the same care as your contract. The right language and disbursement structure will keep your 1031 exchange airtight.

🔍 Frequently Asked Questions: 1031 Exchange Closing Costs

Q1. What if I accidentally pay unqualified closing costs with 1031 exchange funds?
If unqualified costs are paid from exchange funds, the IRS may treat that amount as boot—a taxable portion of your proceeds. The exchange still goes through, but you’ll owe capital gains tax on the boot. Talk to your tax advisor immediately; minor issues may be fixed if caught early.

Q2. How can I make sure the Qualified Intermediary and escrow officer don’t misuse exchange funds?
Communicate early and clearly. Provide written instructions identifying qualified vs. unqualified expenses. Request that only qualified costs be paid from exchange funds, and review a draft settlement statement before funding. Your CPA or QI should sign off before closing.

Q3. My replacement property includes prorated taxes or rent credits—can I avoid triggering boot?
Yes. Negotiate to have these items removed from the settlement statement and instead adjust the purchase price or fund them with personal money. This strategy prevents boot and keeps your exchange fully compliant.

Need help reviewing your 1031 closing documents?
Reach out for a second opinion before you sign. A 10-minute review could save you thousands in avoidable taxes.