When engaging in an IRC 1031 Tax Deferred Exchange, it is important to note that the use of your exchange proceeds to pay some of your closing costs for the relinquished and replacement properties may result in "boot". Boot is any property received in an exchange that is not like kind to the property disposed of in the exchange. In a real property transaction, property received that is not like kind may include such items as cash, a mortgage note, a boat, or stock. The exchanger pays taxes on the boot to the extend of realized capital gain.

The authority addressing the treatment of exchange expenses is limited. Revenue Ruling 72-456 however, does provide that brokerage commissions reduce the realized gain and recognized gain in the taxpayer and increases the tax basis of the replacement property. No specific authority exists for the deduction of any transactional cost from realized gain other than commission, PLR8328011, however implies that other transactional expenses should be disregarded if paid from the exchange proceeds in connection with the exchange. These costs are referred to as "exchange expenses" on IRS Tax Form 8824, but are not specifically listed anywhere. The questions then becomes "what is an exchange expense"? The following is a list of items that most tax practitioners consider allowable exchange expenses for purposes of reducing realized gain and recognized gain:

- Exchange or Accommodator fees
- Messenger fees
- Escrow, Processing and Statement fees
- Finder fees
- Tax service fees
- Inspection and testing fees
- Notary and Recording fees
- Brokerage commissions
- Title insurance premiums
- Documentary Transfer taxes
- Legal/Consulting fees incurred in the transaction

Likewise, the following is a list of closing costs that are not considered exchange expenses and may be treated as boot:

- Rents
- Security Deposits
- Utilities
- Property taxes
- Property Insurance
- Association dues
- Repairs and Termite work
- Credits to Buyers fro non-recurring closing costs or repairs
- Loan Acquisition fees (such as points, mortgage insurance, application fees, lender's title insurance, assumption fees, appraisal fees, hazardous waste/property inspections required by the lender)

While these items may result in taxable boot, they may also be deductible as interest, taxes or operating expenses (subject to the passive loss limitation of IRC 469). See IRC 162, 163, 164, 1001 (b).

Security deposits are cash boot if held in a separate account by the landlord and are mortgage boot, if not required to be segregated. Accordingly, where a security deposit can be classified as mortgage boot, it may not be necessary to bring the security deposits into the closing of the relinquished property if the Exchanger intends to acquire equal or more debt or bring additional cash in for the purchase of the replacement property.

In general, selling expenses, both allowable and non-allowable may be paid at any time during the exchange period without affecting the safe harbors under Reg 1.1031 (k)-1(g) if they are transactional items under Reg. 1.1031(k)-1(g)7. Transactional items are defined by the regulations as items that relate to the disposition of the relinquished property or the acquisition of the replacement property and appear under local standards in the typical closing statement as the responsibility of the buyer or seller. Reg 1.1031 (d)1(g)7(ii). It should be noted that loan acquisition fees such as loan fees, points, appraisal fees, assumption fees, lender's title insurance and other costs related to the loan are costs associated with obtaining the loan and should not be paid for with exchange proceeds.

Disclosure Note: This information is subject to interpretation and meant to help the consumer understand information surrounding a transactional nature for 1031 exchange. It is important to seek specific and individual guidance and information from you financial advisor. This information is merely an overview and is not intended to be exhaustive. Consult with your tax advisor to determine whether an exchange is appropriate for your circumstances.