1031 exchanges are an excellent way to reduce your taxes and build wealth. But what are the actual costs associated with doing one? In this article you will find a complete breakdown of all the fees associated with properly carrying out a 1031 exchange. For an in depth understanding of how to do a 1031 exchange, see our article The Ultimate 2022 Guide to 1031 Exchanges.
How much does a 1031 exchange typically cost in total?
For a standard 1031 exchange where you sell a property and replace it, you are looking at fees in the range of $800 to $1,200. These are fees that you will pay to a qualified intermediary (QI). This is the company who will hold onto the funds in the time between selling your property and closing on the replacement property.
If you want to do a more complex 1031 exchange such as a reverse 1031 exchange (buying the replacement property before selling your current property) you are looking at substantially bigger fees that could range anywhere from $3,000 to $8,000.
What exactly do QIs charge you for?
The QI plays a big part in executing a successful 1031 exchange. This company will take care of most of the paperwork that will need to be filed with the IRS in order to complete the 1031 exchange.
Here’s the services you should expect to receive from a good QI:
- Documentation of the exchange. This would include all necessary paperwork to show the IRS that you have complied with the rules for the 1031 exchange.
- Holding your money in escrow. The whole idea is that in order to qualify for the 1031 exchange, you cannot touch the money. The QI will hold the money in a secure account until the new property is closed on.
- Audit assistance. In the event your 1031 exchange is subject to an audit by the IRS, a good QI will offer assistance in providing the proper documentation.
- Additional properties. Typically you’re looking at an additional three to four hundred dollars per property identified as a replacement property.
Tax Impact Of Exchange Expenses Vs. Non-Exchange Expenses
There are a variety of fees that can be paid from the sale of your relinquished property. Of course you cannot ever touch the money from that sale, because doing so would cancel the 1031 exchange. But this money can be used for expenses incurred in the process of acquiring the new property.
Here are some common allowed exchange expenses:
- Purchase appraisal costs. These are the costs paid to an expert to accurately determine the value of the replacement property.
- Attorney fees. Fees paid to attorneys related to acquiring the new property.
- Broker commission. Any fee paid to a broker when purchasing the new property.
- Escrow fees. These are fees charged for holding your money from the time you sold your property to buying the new one.
- Transfer taxes. This is a small tax of 1% to 3% charged in the transfer of ownership of a property.
- Inspection fees. These are fees associated with doing due diligence on the property.
- Prorated taxes. This would be the amount of property tax owed for the property for the remainder of the year, since typically these taxes are paid on a yearly basis.
- Recording fee. This is a fee paid to the local government to officially record the transfer of title.
- Title insurance. This is paid to the title company, who guarantees that you have the rights to the property.
Anything associated with the purchase or closing costs of the property are considered exchange expenses and can be paid from the sale of your relinquished property. However, if you use exchange funds for certain other expenses, you will end up paying extra taxes.
Here are some fees that cannot be covered by exchange funds:
- Financing costs
- Security deposits
- Appraisal costs from a lender
- Environmental checks required by a lender
- Any fees related to getting a loan
- Anything not directly related to purchasing the property
If you were to imagine buying the property in cash, you could use your exchange funds for anything that would typically occur in such a transaction i.e. normal closing costs. Anything else paid from exchange funds will be subject to tax.
For example, let’s say you sell a property for $500,000 and are doing a 1031 exchange. If you were to have $10,000 worth of lender appraisal costs and environmental checks paid for out of your escrow account, this money would be subject to tax.
Overall it’s safer to use exchange funds only for costs directly related to acquiring the property. Paying money from exchange funds can get into a gray area with the IRS, so make sure whoever is helping you do the paperwork on the exchange is aware of these kinds of rules.
How To Choose a Qualified Intermediary
The QI you choose is going to play a big role in successfully executing the 1031 exchange, so it’s important to pick carefully. Beyond price, there are a few things you should consider when selecting a company to work with.
Level Of Customer Service Desired
Depending on your level of experience you may need a greater or lesser degree of help doing the exchange. Small law firms do 1031 exchanges and can provide a lot of one on one consultation. The downside here is they typically do a lot less of these, and may not be completely up to date on current 1031 exchange rules. That means you might end up paying a lot more.
If you’re more experienced you can go with an online company or a big national firm who does primarily 1031 exchanges. You’ll pay less and get less one-on-one support, but if you know what you’re doing, you might not need it.
Amount of Experience
Your best bet for experience would be a big national company who specializes in 1031 exchanges. They will be up to date on all recent rulings in your local jurisdiction so you won’t have to worry about something going wrong. There can be a lot of gray area subject to interpretation with certain aspects of 1031 exchanges, so the more experience your QI has, the better. However, if you know all about this yourself, you may want to go with an online company who will simply hold the funds for you and do all the necessary paperwork.
Degree Of Education and Support Offered
If this is your first time doing a 1031 exchange, you’ll want to choose a company who will be willing to walk you through the whole process. For example, your QI could offer the service of reminding you about the 45 day window to identify the new property. You should have a conversation with any prospective QI to determine what level of service they will be offering. That way you can decide if they will educate you through the process to an adequate degree.
To a large extent QIs are unregulated. This is why picking a reputable company is so important, since after all, they will be holding onto your money for up to six months. But you can protect yourself further by choosing a QI who resides in a jurisdiction that mandates the QI have a crime bond. A crime bond means that if the QI runs off with your money, you would be covered.
How Qualified Intermediaries Make Money
You may be thinking that the fees charged by the QI are small considering all of the documentation they need to do. But that’s because they make their money in a different way–through interest. During the time your money is sitting in escrow they will be collecting interest on that money.
You should find out how much of this interest the QI actually takes. In some cases there will be a percentage split between you and the QI on the interest.
The Bottom Line
When determining the costs of doing a 1031 exchange, you’re primarily looking at the fees paid to a QI. The good thing about these costs is that they can be paid from the sale of your property without affecting your taxes. When choosing a QI, make sure the company gives you a full breakdown of what you’re covered for. 1031 exchange costs are relatively small if doing a standard 1031 exchange, and are generally not a deterrent to doing one, considering all the costs can be paid from the sale of your property.