Is it OK to Use Your 1031 Exchange Proceeds to Pay Your Legal Fees?

Many people ask if they can pay their legal fees out of the proceeds from the sale of their old relinquished property in a 1031 exchange.

Fees Related to Your 1031 Exchange

The answer to the question is yes, if the legal fees relate to your 1031 exchange or relate to the real estate matter. However, you can’t pay unrelated legal fees out of the 1031 sales proceeds. For example, if you were doing estate planning or had a criminal action unrelated to your 1031 exchange – those cannot be paid out of the net proceeds. You can’t pay legal fees unrelated to your transaction.

Treasury Regulations

The treasury regulations state that you can pay ordinary, standard, customary transactional expenses out of the exchange funds and certainly your legal fees related to the exchange are ordinary and customary.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2023 Copyright Jeffrey R. Peterson All Rights Reserved

Video - The Importance of Cognitive Intent in a 1031 Exchange

When you’re doing a 1031 exchange you need to walk like a duck and talk like a duck so that the IRS interprets your 1031 exchange as being a qualifying exchange. What we mean by “talking and walking like a duck” is that you have to hold your properties involved in a 1031 exchange for a qualifying purpose which is investment or business purposes.

Many clients think in the indeterminate long-term that they may want to convert their replacement property into personal use down the road. Well, for the first two years after you acquire that property, it may be a good idea to rent it out or otherwise hold it for investment or business purposes, and not convert it to personal use prematurely because you want to be able to substantiate that you had the right intention with the property. There’s really no way to know what’s really going on in a person’s head so the IRS has to interpret what you do with the property. Renting out the property, using it for investment or business purposes for a substantial period of time is probably the best way to prove that you had the right cognitive intent.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2023 Copyright Jeffrey R. Peterson All Rights Reserved

Video - How to Calculate Capital Gains in a 1031 Exchange

Capital gains are not calculated based on the amount of proceeds that you walk away from a closing with. Capital gains are determined by the difference between your adjusted basis and the net sale price. Let’s say that you bought a property or a million dollars and over time it appreciated to two million dollars. Your original cost basis was a million dollars but over time you may have whittled down your basis to some lower number through depreciation deductions. In order to know what the gain is you need to know how much it appreciated (or increased in value) over time, and you also need to be cognizant of how much your basis declined as a result of depreciation deductions. Your total gain is the difference between your current low adjusted basis and the net selling price (net of only the transactional costs of the sale such as your commission and other amounts that reduce the amounts realized). So gains are not determined by how much cash you have, but the difference between your basis and the net selling price.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2023 Copyright Jeffrey R. Peterson All Rights Reserved

Can I Do a 1031 Exchange with Business Property?

Many taxpayers are entrepreneurial. They might be in one business segment and want to 1031 exchange into a new business segment. For example, a restaurant owner might want to sell their restaurant and buy a hotel. How can this be an exchange? Isn’t a restaurant fundamentally different than a hotel?

Real Estate

In the realm of 1031 exchange, pretty much all real estate is considered like-kind. So if we’re dealing with only the real estate, it’s really easy to do an exchange from a restaurant building to a hotel building. As long as they’re both in the US and used for investment or business purposes, they’re like-kind.

Other Elements or Components

Other types of assets (other than real property) that may be involved in the sale, like the restaurant equipment or hotel furnishings – those types of property are not eligible for 1031 exchange treatment and should be left out of the 1031 transaction.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2023 Copyright Jeffrey R. Peterson All Rights Reserved

Video - 1031 Exchanges Involving Refinancing

What if you do a 1031 exchange and you reinvest all of your equity into the replacement property and then after you acquire the replacement property you find that you’re short of cash? You may have an unforeseen vacancy or repair expense, and you may conclude that you need to refinance your replacement property. Is that going to trigger gains from the sale of your relinquished property if you’re drawing out the equity?

Generally, as long as the refinance is done in a separate, subsequent transaction, it will not trigger gains. Please consult with your tax attorney and other advisors regarding this. You may want to separate your refinance and your purchase closing so that there is a substantial period of time between these two transactions. You don’t want to give the IRS the argument that the purchase closing and the refinance closing were one continuous transaction.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2023 Copyright Jeffrey R. Peterson All Rights Reserved