Which closing costs can be paid from exchange funds without creating boot?

Every line on the statement has to pass two different tests, and most lists only run the first

Test one asks whether funding the item from the intermediary's account breaks the safe harbor. Treas. Reg. §1.1031(k)-1(g)(7)(ii) disregards 'transactional items that relate to the disposition of the relinquished property or to the acquisition of the replacement property and appear under local standards in the typical closing statements as the responsibility of a buyer or seller (e.g., commissions, prorated taxes, recording or transfer taxes, and title company fees).'

Test two asks whether the item reduces the money you are treated as receiving. That answer comes from the form, not the regulation: the Form 8824 instructions tell you to add cash received, other property and net liabilities assumed by the other party on line 15, then 'reduce the sum of the above amounts (but not below zero) by any exchange expenses you incurred.'

The two tests do not always agree, and the gap is where sellers get surprised. Prorated taxes are named in (g)(7)(ii), so paying them does not blow the safe harbor, yet they are not an expense of disposing of the property and do not shrink line 15.

The items that clear both tests and therefore cut your taxable boot

These are the costs of moving title. Rev. Rul. 72-456, the oldest authority practitioners cite here, holds that real estate brokers' commissions paid are offset against cash received in computing gain and are added to basis, which is exactly the line 15 and line 18 mechanic the modern form uses.

Whatever you do not use to reduce line 15 is not lost. Line 18 of Form 8824 takes 'exchange expenses, if any (except for expenses used to reduce the amount reported on line 15)', so the remainder lifts your basis in the replacement property and comes back as depreciation.

• Brokerage and finder's commissions on both sides of the trade.
• Owner's title insurance premium, escrow, settlement and closing-agent fees, notary and recording charges.
• State, county and city transfer, documentary stamp and deed taxes.
• The qualified intermediary's exchange fee (what it runs).
• Attorney and accountant fees for the sale and the purchase themselves, plus survey and acquisition-side appraisal or environmental work you commissioned rather than the lender.

Lender charges are the biggest single trap, and they fail test two outright

Points, origination and application fees, the lender's title policy, a lender-ordered appraisal, credit reports, mortgage insurance and escrow impounds all exist because you financed the purchase, not because you acquired the building. They are neither an expense of disposing of the relinquished property nor part of the replacement's cost, so neither line 15 nor line 18 has a slot for them.

Legal 1031 and IPX1031 both put the whole lender column on the boot side. The full argument, the amounts at stake and the two ways practitioners handle it are in do loan fees, points and rate buy-downs count as boot.

Repairs, tenant buyouts, code-violation fines, association dues, hazard insurance and utility charges fail the same way: they are operating costs of owning, not costs of transferring.

Prorations and credits: neutral on paper, corrosive in practice

A real property tax proration is the quiet one. Reg. §1.1001-1(b) says a seller who pays taxes for the year of sale 'shall not take into account, in determining the amount realized from the sale under section 1001(b), any amount received as reimbursement for taxes which are treated under section 164(d) as imposed upon the purchaser.' The credit therefore leaves both your proceeds and your amount realized smaller, so it creates no boot by itself.

It still costs you, because it lowers the cash the intermediary holds while your reinvestment target is measured from a sale price that included it. On the buy side the same item flips: reimbursing your seller for prepaid taxes is not part of your purchase price, so funding it from exchange money spends exchange money on your own future expense.

Tenant money is a separate problem with its own answer in are security deposits and rent prorations boot.

Worked example: a hypothetical $1,000,000 sale with $62,000 of closing costs

Assume a $1,000,000 sale, a $250,000 adjusted basis and no mortgage. The statement shows $50,000 of commission, $6,500 of title and escrow, $4,500 of transfer tax, $1,000 to the intermediary, and a $7,000 property tax proration credited to the buyer. The intermediary is wired $931,000.

Qualifying exchange expenses total $62,000 and come straight off line 15 before boot is measured. The $7,000 tax credit sits outside the amount realized under Reg. §1.1001-1(b), so your reinvestment target is the same $931,000 the intermediary is holding. Buy the replacement at $931,000 and nothing is recognized.

Now add $3,000 of lender points at the replacement closing. Let the intermediary pay them and only $928,000 of exchange money reaches the seller, so $3,000 is recognized and you still have to close the $3,000 gap in the purchase price out of pocket. Wire that $3,000 yourself in the first place and the cash is identical, the tax is not. IRS Publication 544 runs the same subtraction in its own example, where $40,000 of money and unlike property received less $5,000 of exchange expenses paid leaves $35,000 of recognized gain.

• Deductible against boot at line 15: commission $50,000, title and escrow $6,500, transfer tax $4,500, intermediary fee $1,000.
• Neutral: the $7,000 property tax proration, excluded from amount realized on both sides of the deal.
• Boot if the intermediary funds it: $3,000 of points, with no offsetting increase in basis.
• Round hypothetical numbers, shown to demonstrate the arithmetic rather than to price a particular deal.

How to give the settlement agent a clean instruction the week before closing

Send the draft settlement statement to your intermediary and your CPA, ask them to mark each line 'exchange funds' or 'personal funds', and return the marked copy to escrow. Confirm the classification with your own CPA or attorney, since the return is yours to sign.

Then keep the marked statement, the closing statements from both sides and the intermediary's accounting together; they are the file that supports lines 15 and 18 if the return is ever examined (what to keep).

Breakwater Exchange is a 1031 exchange broker with more than twenty years of experience, and we read draft settlement statements with exchangers before closing as a matter of course.