What Closing Costs Can You Pay With 1031 Proceeds?

Closing costs in a §1031 exchange split into two categories: exchange expenses (deductible from proceeds without boot consequences) and non-exchange items (which create boot if paid from proceeds). The IRS has not published a single comprehensive list, but a series of Private Letter Rulings and longstanding practice have established a working safe harbor that QIs and tax practitioners follow.

The IRS 'Exchange Expense' Safe Harbor (PLRs)

The §1031 regulations do not explicitly enumerate which closing costs can be paid from exchange proceeds without creating boot. The framework comes from a series of Private Letter Rulings (notably PLR 8328011 and subsequent rulings) and Revenue Ruling 72-456, which establish that "ordinary and necessary expenses of the exchange" are deductible from proceeds without creating boot.

The working test: an expense is exchange-eligible if it is (a) directly attributable to the sale or purchase as a real estate transaction, and (b) typically paid by a buyer or seller in the locality. Expenses that are personal to the taxpayer, prepaid carrying costs, or financing-related are typically not exchange-eligible.

PLRs are not binding precedent, but the consistent IRS position across multiple rulings and decades of practice gives taxpayers and QIs a reliable framework. Audit risk is low when expenses fall clearly within the safe-harbor list and high when they fall outside.

Allowable Expenses That Don't Create Boot

The standard safe-harbor list includes:

• QI fees. The Qualified Intermediary's fee for handling the exchange. Simple 1031 LLC charges $799 flat for forward exchanges and $1,500 for reverse and improvement exchanges.
• Title insurance. Owner's title insurance and closing protection letters on both the relinquished sale and the replacement purchase.
• Escrow and settlement fees. Escrow company fees, settlement agent fees, and closing protection costs.
• Recording fees. County recording fees for the deed and any other documents recorded as part of the transfer.
• Real estate broker commissions. Listing broker commissions on the relinquished sale and buyer's broker commissions on the replacement purchase.
• Legal fees attributable to the exchange. Attorney fees for drafting or reviewing the purchase contract, sale contract, deed, and exchange documents.
• Tax-deferred exchange documentation costs. The legal/QI cost of preparing the exchange agreement, identification documents, and assignments.
• Notary and document preparation fees. Standard closing-table notary and document fees.
• Transfer taxes. Real estate transfer taxes imposed by state or local authority on the deed.
• Survey fees. If a survey is required for the transaction.
• Pest, structural, and environmental inspections. Standard inspection costs typically paid by buyer or seller.

These items can be paid from exchange proceeds at relinquished or replacement closing without creating boot. The HUD-1 or Closing Disclosure typically lists them in the seller's-side or buyer's-side cost section.

Non-Exchange Costs That Do Create Boot

The following items typically create boot if paid from §1031 proceeds because they are not "expenses of the exchange" but personal or financing costs:

• Property tax prorations. The pro-rata share of unpaid property taxes credited from seller to buyer (or vice versa) is not an exchange expense — it is a carrying-cost adjustment between the parties. If paid from proceeds, the proration creates boot.
• Prepaid insurance. Prepaid casualty insurance premiums on the replacement, paid at closing, are personal carrying costs and create boot.
• HOA dues and assessments. Homeowners' association prorations and any prepaid HOA assessments are carrying costs, not exchange expenses.
• Utility prorations. Pro-rata utility credits are carrying-cost adjustments, not exchange expenses.
• Loan origination fees. Points, origination fees, lender's title insurance, and other costs of new financing are financing costs, not exchange expenses. They belong to the new loan, not the §1031.
• Loan payoff penalties. Prepayment penalties on the relinquished loan are typically debt-related, not exchange-related.
• Per diem interest. Daily interest on the new loan from closing date to first payment is a financing cost.
• Rent prorations. Tenant security deposits, prepaid rent, and rent prorations are carrying costs and not exchange expenses.

The fix when these items appear at closing: pay them from outside funds (taxpayer's checking account) rather than from QI exchange escrow. Keeping them off the exchange proceeds preserves the §1031 deferral on the full equity amount.

Broker Commissions (Allowed)

Real estate broker commissions are exchange-eligible expenses. The listing commission on the relinquished sale (typically 5-6% of sale price, split between listing and buyer's broker) and the buyer's commission on the replacement purchase both come out of exchange proceeds without creating boot.

This is the largest single closing cost in most exchanges and the most important to get right. A $700K relinquished sale at 6% commission = $42K commission, which would be $42K of taxable boot if mishandled. The standard mechanic: the title company pays commissions at closing from sale proceeds, and the QI receives the net amount after commissions and other allowable closing costs.

Financing Costs (Separate Transaction)

All costs of the new loan on the replacement — origination fees, points, lender's title insurance, appraisal fees ordered by the lender, credit report fees, processing fees, underwriting fees, lender's attorney fees — are financing costs, not exchange expenses. They cannot be paid from §1031 proceeds without creating boot.

Practical approach: financing costs are paid from the new loan proceeds (rolled into the loan amount) or from the taxpayer's outside funds at closing. The HUD-1 or Closing Disclosure separates loan costs from settlement costs, and the QI's exchange funds should only fund the settlement-cost side, not the loan-cost side.

Worked HUD-1 / Closing Disclosure Example

Replacement closing at $800K purchase price, $300K from QI exchange escrow, $500K new loan, taxpayer adds $50K fresh cash:

• Purchase price: $800K (paid from QI + new loan = $800K).
• Title insurance: $2,500 (exchange expense — paid from QI).
• Escrow fee: $1,500 (exchange expense — paid from QI).
• Recording fee: $200 (exchange expense — paid from QI).
• Property tax proration: $1,800 (non-exchange — paid from taxpayer's outside cash).
• Prepaid insurance: $1,200 (non-exchange — paid from taxpayer's outside cash).
• Loan origination fee: $4,000 (financing cost — rolled into loan).
• Loan title insurance: $800 (financing cost — rolled into loan).

The QI funds the purchase price + exchange-eligible closing costs ($800K + $4,200 = $804,200). The taxpayer's $50K fresh cash covers the $4,200 exchange costs above the QI's $300K + $500K loan, plus the $3,000 in non-exchange items. No boot created on either side.

Simple 1031 LLC reviews the HUD-1 or Closing Disclosure on every exchange before closing to flag boot-creating line items. We are a Qualified Intermediary and do not provide tax, legal, or investment advice — the final analysis on which items create boot in your specific transaction should be reviewed with your CPA before closing.

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