In a 1031 exchange, you have to be very careful in handling your expenses. What are qualified exchange expenses that you may use on your 1031 closing expense sheet, and what are non-qualified expenses?
A General Rule
The general rule is you’re supposed to move all of your equity from the sale of the relinquished property into the new replacement property. However, the exception to the rule is that you can pay certain qualifying expenses. The classic example is the real estate agent's commission on the relinquished property. You can also pay the title company, the county recorder, and other customary expenses that would be seen in that locality.
Non-Qualified Expenses
You probably can't put your Home Depot credit card bill or your Netflix charges on the settlement statement because you don't customarily see those expenses on closing statement and they're probably not related to the sale of the relinquished property.
Debt
Sometimes people want to pay off debt that may or may not be secured by the property. While that is not really an expense related to the sale, it is a cloud on title that oftentimes has to be removed in order to convey marketable title to the buyer. If the debt is secured by a mortgage or other lien it's clear that it has to be paid and is appropriate to be paid on the settlement statement.
Where it gets a little dicey are notes and other loans that may not necessarily be secured by the property, or encumber the property but for which there is a contractual requirement that the debt has to be paid if the property is ever sold. In those situations, the IRS will permit you to use exchange funds to pay off that debt that you are contractually required to pay, and you may be able to offset that debt relief with new debt on the replacement property so that the old debt does not trigger boot or mortgage boot on the sale of your old relinquished property.
Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.
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