Does a prepayment penalty on my old loan count as a closing expense or boot?

A prepayment penalty is interest on the old loan, not a cost of selling the building

For home mortgages, Publication 936 says you can deduct a prepayment penalty 'as home mortgage interest provided the penalty isn't for a specific service performed or cost incurred in connection with your mortgage loan.' The charge pays the lender for the use of its money ending early, so it belongs with the loan, not with the deed.

That matters because the exchange regulations draw a line around costs of the transfer itself. Reg. section 1.1031(k)-1(g)(7)(ii) disregards 'transactional items that relate to the disposition of the relinquished property... and appear under local standards in the typical closing statements as the responsibility of a buyer or seller', and its examples are commissions, prorated taxes, recording or transfer taxes and title company fees. A financing charge on your own debt is not of that kind.

The Form 8824 instructions let exchange expenses reduce the cash and net debt relief you report on line 15. Because the penalty is interest rather than an expense of the exchange, it does not belong in that reduction.

Paid from sale proceeds, the penalty is generally treated as cash you took

Escrow normally pays your loan from the buyer's money before anything reaches the intermediary. The principal payoff is fine: it is debt relief, which Reg. section 1.1031(d)-2 treats as money received but lets you offset with debt you take on or cash you add on the replacement.

The penalty line is different. Proceeds that could have gone to the intermediary went instead to pay a personal interest obligation, which is economically the same as handing you the cash and having you write the check. That is boot, recognized up to your realized gain under section 1031(b).

Because boot is generally taxed from the depreciation layer first, the penalty dollars are usually taxed at the up-to-25% rate on unrecaptured section 1250 gain in Topic 409. The ordering is explained in is boot taxed as recapture or capital gain first.

Worked example: a $15,000 penalty on a $900,000 sale

Hypothetical, round numbers, state tax ignored; run your own numbers with your CPA. You sell a rental for $900,000 with a $400,000 loan and a $15,000 prepayment penalty. Your adjusted basis is $400,000 after $150,000 of depreciation, so the realized gain is $500,000. You buy a $900,000 replacement with a new $400,000 loan.

If escrow pays the penalty, the intermediary receives $15,000 less, and you have $15,000 of boot. At 25% that is $3,750, plus the 3.8% net investment income tax of $570 if your income is above the threshold: about $4,320. You also need $15,000 more of your own cash at the replacement closing to keep the purchase price whole.

If you bring a $15,000 cashier's check to the sale closing for the penalty, the intermediary receives the full net proceeds and you recognize nothing. In both versions you spent $15,000 and have a $15,000 interest cost; only one of them also triggers about $4,300 of federal tax.

• Same cash out of pocket either way: $15,000.
• Penalty from proceeds: $15,000 boot and roughly $4,300 federal tax.
• Penalty from outside cash: no boot, no tax from the exchange.

What to do before the payoff letter is final

Ask your lender for the payoff letter early and have escrow show the penalty as its own line on the settlement statement, not folded into principal. The separation tells your CPA what the charge was and shows the intermediary which dollars were yours.

Then tell escrow in writing that you will fund the penalty separately. Ask the closing agent to accept a deposit from you at the sale closing for that line, so the exchange proceeds stay whole. The general rule for which costs exchange funds can pay is in can closing costs be paid from exchange funds, and the companion question on lender charges for your new loan is in loan fees and points paid from exchange funds.

If the penalty is large, look at the loan documents for alternatives before closing. A buyer assuming the existing loan avoids the penalty entirely, which is the subject of can a buyer assume my low-rate mortgage.

A trust interest does not change the penalty but can absorb the cash you add back

Nothing on the replacement side cures boot already taken on the sale side, so the penalty decision has to be made at the sale closing. What the replacement side can do is take the exact amount you have left to place, including any outside cash you add to keep the purchase price whole.

A Delaware Statutory Trust interest can be sized to an odd dollar figure and carries its share of the trust's own loan, which helps if paying off the old loan leaves you short of replacement debt; see does a DST's loan count as replacement debt and our traditional DST page.