The exchange was clean. A $1.2 million sale, a qualified intermediary engaged before closing, replacement property identified on day nine, everything closed inside the window. Our client did all of it right.
Then his CPA called in February with a $4,760 tax bill he was not expecting.
Nothing had gone wrong with the exchange. The problem was three lines on the settlement statement, none of which anyone had thought about, all of which had been paid out of exchange proceeds. That is the whole story, and it happens constantly.
Two kinds of money leave the closing table
Every closing pays out a pile of items. For 1031 purposes they fall into two categories, and the distinction is not intuitive until you see the logic behind it.
Transactional expenses are the costs of transferring the property itself. Paying these from exchange proceeds is fine. They reduce your amount realized rather than landing in your pocket, so no boot results.
Everything else is, in substance, cash that would otherwise have come to you. When exchange funds pay it, the IRS view is that you received the money and spent it. That is boot, and boot is taxable to the extent of your gain.
The rule of thumb that survives contact with actual closings:
Costs of transferring the property can come out of exchange funds. Costs of operating the property or obtaining financing cannot.
The two lists
| Generally safe from exchange funds | Generally creates boot |
|---|---|
| Broker and agent commissions | Security deposits transferred to the buyer |
| Title insurance premiums | Prorated rent credited to the buyer |
| Escrow and closing agent fees | Property tax prorations credited to the buyer |
| Qualified intermediary fees | Prepaid insurance and utility prorations |
| Recording fees and transfer taxes | HOA dues and assessments |
| Legal and tax advice on the exchange | Lender points, loan origination, and application fees |
| Appraisal required by the contract | Appraisal or survey required by the lender |
| Exchange-related notary and courier costs | Repairs credited to the buyer |
The financing side surprises people most. Costs of getting a loan on your replacement property are not costs of acquiring real estate, they are costs of borrowing. Paying them with exchange funds is a boot event, even though the loan exists only because of the purchase.
What it actually costs
Take that $1.2 million sale. The transactional column behaves exactly as you would hope:
| Item | Amount | Effect |
|---|---|---|
| Broker commission (5%) | $60,000 | Reduces amount realized |
| Title, escrow, recording | $8,000 | Reduces amount realized |
| Qualified intermediary fee | $1,200 | Reduces amount realized |
| Transfer tax | $6,600 | Reduces amount realized |
Now the other column, all of it paid out of proceeds because nobody flagged it:
| Item | Amount | Effect |
|---|---|---|
| Security deposits to buyer | $9,400 | Boot |
| Prorated rent to buyer | $3,100 | Boot |
| Property tax proration | $7,500 | Boot |
| Total boot | $20,000 | Taxable |
At a 20% capital gains rate plus the 3.8% net investment income tax, that is roughly $4,760. On a transaction where nothing went wrong.
The fix costs nothing. Bring $20,000 of your own money to the closing, or handle those prorations outside of closing entirely, and the boot disappears. Same economics, same net cash position, $4,760 saved.
The netting point worth knowing
There is a softer landing available in some cases. Items like prorated taxes and security deposits credited to the buyer can be characterized as the functional equivalent of nonrecourse liability relief. Where that treatment applies, the resulting mortgage boot can be netted against new debt you take on with the replacement property.
If your replacement financing is larger than the debt you were relieved of, that netting may absorb the whole issue. If it is not, you are back to writing a check.
This is genuinely a facts-and-circumstances area and different intermediaries take different positions on it. Do not assume the netting will save you. Ask before closing, not after.
Do this three days before closing
- Get the draft settlement statement early. Not the morning of. Three business days gives you time to move things.
- Read it line by line with your QI and CPA. Both, not one. Intermediaries know the safe harbor, CPAs know your basis and gain.
- Decide which items you will fund personally. Then actually wire that money separately.
- Handle rent and deposit adjustments outside of closing where the parties will agree to it. Cleanest possible outcome.
- Watch the replacement side too. Lender fees on the purchase are the most commonly missed item of all.
For the mechanics around this, see our exchange overview, what a 1031 exchange costs, and how boot netting works. If cash is coming out on purpose rather than by accident, partial exchanges covers that deliberately.
Your CPA determines the correct treatment of any specific line on your settlement statement.
Questions we field about closing costs
Can I pay my qualified intermediary fee from exchange proceeds?
Yes. QI fees are transactional expenses directly connected to the exchange and are routinely paid from proceeds without creating boot.
Why are lender fees treated differently from title fees?
Title work is part of transferring the real estate. Loan points and origination fees are the cost of borrowing money, a separate transaction that happens to occur at the same table.
What if the boot is small? Does it still matter?
Boot is taxable to the extent of your gain, with no de minimis exception. A small amount produces a small bill rather than no bill.
Can I just have the buyer pay the prorations?
You can negotiate who writes which check, but the economics usually get priced into the sale. The reliable fix is funding the items yourself rather than from exchange proceeds.
Does paying a repair credit to the buyer create boot?
Typically yes, if funded from exchange proceeds. A credit for repairs is generally treated as cash to the buyer rather than a cost of transferring title.