Exchange-related costs (QI fees, exchange counsel, title insurance, recording fees, transfer taxes, seller-side commissions) can be paid from proceeds without creating boot. Non-exchange costs (lender origination fees, points, inspection fees, repair credits) paid from exchange proceeds may create boot. Review the preliminary HUD-1 at least five business days before closing and coordinate cost allocation with the QI.
Why Closing Costs Matter in an Exchange
A lender's appraisal fee and a $10,000 credit to the buyer for a roof repair are ordinary line items in a normal closing. Inside a 1031 exchange, either one can quietly turn part of a tax-deferred deal into a taxable one, depending on how it is paid and where it sits on the settlement statement.
The reason has a name: boot. Boot is the cash or debt relief a taxpayer walks away with in an exchange, and the IRS treats it as taxable gain. Closing costs feed that calculation. The treatment of each cost affects whether boot is created, how basis is computed, and how much of the exchange's tax benefit survives. A cost that is perfectly normal in a standard transaction can trigger boot in an exchange if it is paid from exchange proceeds or allocated incorrectly.
That puts closing-cost review on your desk: check costs before closing, coordinate with the qualified intermediary (the QI, the third party that holds the exchange proceeds) and the title company, and confirm each cost is allocated correctly.
Which Costs Can Come From Exchange Proceeds
Exchange-related costs can be paid from exchange proceeds without creating boot. These are the costs tied directly to acquiring the replacement property.
Non-exchange-related costs are the trap. Paid from exchange proceeds, they can create boot, because they put cash or value somewhere other than the acquisition itself.
Closing Cost Reference Table
Cost Type | Exchange-Related? | Notes |
|---|---|---|
Qualified intermediary fees | Yes | Integral to the exchange structure. Paid from proceeds. |
Exchange counsel fees | Yes | Legal fees for structuring and reviewing the exchange itself. |
Title insurance (owner's policy) | Yes | Protects the taxpayer's interest in replacement property. |
Title insurance (lender's policy) | No | Financing cost; lender or borrower pays separately. |
Title examination | Yes | Title company's examination of title. |
Deed preparation | Yes | Preparing the deed for replacement property. |
Recording fees | Yes | Recording the new deed with the county. |
Transfer taxes / documentary stamps | Yes | State and local taxes on the property transfer. |
Escrow / closing fees | Yes | Title company's service fee for handling the transaction. |
Survey / boundary verification | Yes | Surveying the replacement property boundaries. |
Flood certification | Yes | Flood zone verification for financing or insurance. |
Real estate commission (seller's side) | Yes | Broker who sold the relinquished property. Usually handled from sale proceeds. |
Real estate commission (buyer's side) | Depends | Clarify with agent and title company whether paid from exchange proceeds or buyer's own funds. |
Lender origination fee | No | Financing cost. Borrower or lender pays separately. |
Lender discount points | No | Pre-paid interest. Financing cost. |
Lender appraisal fee | No | Lender's cost for property appraisal. |
Lender inspection / underwriting | No | Lender's processing costs. |
Property inspection (buyer's) | No | Buyer's due diligence cost. Buyer pays directly. |
Home warranty | No | Optional insurance. Not a cost of acquisition. |
HOA transfer fee | Depends | If tied to transferring title, may be exchange-related. If a membership or reserve assessment, it is not. Verify with HOA. |
Repair credits / concessions | Depends | See repair credit guidance below. |
Insurance binder | No | Buyer's insurance. Buyer pays directly. |
Prorated property taxes | N/A | Settlement adjustment; does not create boot. |
Prorated HOA dues | N/A | Settlement adjustment; does not create boot. |
Prorated utilities | N/A | Settlement adjustment; does not create boot. |
Repair Credits and Concessions: Decision Tree
How a seller concession is documented on the settlement statement decides its tax treatment.
Scenario | Settlement Statement Shows | Tax Consequence | Recommended? |
|---|---|---|---|
Price reduction | "Purchase price $490,000 (reflecting $10,000 credit for roof repair)" | Buyer's basis is $490,000. No boot created. | Yes |
Separate line item | "Purchase price $500,000" and "Seller repair credit $10,000" separately | Ambiguous. IRS may treat as price reduction or as separate payment (boot). | Avoid |
Cash credit | Buyer receives $10,000 cash from seller | Unambiguous boot. Buyer recognizes gain up to $10,000. | No |
Best practice: Negotiate the purchase agreement so the price already reflects any seller concession, and have the agreement state that net price. At closing, the deed and settlement statement should show the net purchase price only.
Settlement Statement Review Checklist
Ask for the preliminary ALTA settlement statement at least five business days before closing.
Sale of Relinquished Property Section
Purchase of Replacement Property Section
Financing Section
Sample Instructions to Title Company
Send written instructions to escrow before closing.
INSTRUCTIONS REGARDING EXCHANGE CLOSING COSTS
To: [Title Company Name] Escrow Department Re: 1031 Exchange Closing Instructions - [Taxpayer Name] Date: [Today]
- Exchange costs paid from proceeds: QI fee, exchange counsel legal fees, title insurance (owner's policy), recording fees, transfer taxes, title examination, deed preparation, escrow fees.
- Financing costs NOT paid from proceeds: Lender origination fee, discount points, lender appraisal, lender inspection, underwriting fees. These are paid by the borrower or lender separately.
- Buyer's due diligence costs NOT paid from proceeds: Inspection, appraisal, environmental review ordered by buyer. Buyer pays directly.
- Repair credits: Reflected as a reduction to purchase price, not as a separate payment to buyer.
- Prorations: Property taxes, HOA dues, and utilities are settlement adjustments; no separate costs.
If any cost or allocation is unclear, contact the undersigned or the QI before closing.
QI: [Name and contact] Advisor: [Name and contact]
Send a copy to the QI, the buyer's lender, and the title company, and confirm receipt.
QI Coordination
Give the QI the preliminary settlement statement at least five business days before closing, and ask:
- Are you comfortable with the costs and allocations shown?
- Which costs will you pay from exchange proceeds?
- Are there any costs you flag as potentially problematic?
- Should I instruct the title company to allocate any costs differently?
Common Scenarios
Scenario | Action |
|---|---|
Lender deducts points from loan proceeds | Approve. Standard financing practice. No boot issue. |
Title company shows repair credit as separate line item | Request purchase price reduction instead. If seller refuses, flag to client and QI. The credit may be boot. |
HOA charges $1,500 transfer fee | Verify with HOA whether it is a transfer fee (exchange-related) or assessment (not exchange-related). Coordinate with QI. |
Lender appraisal exceeds purchase price | No issue. Purchase price controls for boot and basis. Appraised value controls for LTV. |
Boot Calculation and Closing Costs
Legitimate acquisition costs paid from exchange proceeds do not create boot. Costs paid from non-exchange funds do not create boot either. Boot appears when the taxpayer receives cash or debt relief as part of the exchange, which is why where a cost is paid from matters as much as what the cost is.
Documentation for Audit Defense
Preserve:
A clear record of how each cost was allocated, and why, supports the taxpayer's position in an audit.
Bottom Line
Closing costs are tax-sensitive in an exchange, and not all of them can be paid from proceeds without consequences. Review the preliminary settlement statement early, categorize each cost against the reference table, coordinate with the QI and title company, and document everything. An hour of review before closing beats days of explaining boot after closing.
Review the settlement statement early, coordinate with title and the QI, and flag any questionable costs before closing.
Frequently asked questions
Can lender fees be paid with exchange funds?
Lender origination fees, points, and other financing costs are generally not paid with exchange funds, because doing so can create boot. The IRS views these as costs of financing, not of acquiring the replacement property; the lender collects them, and they do not reduce the taxpayer's net proceeds. If the QI pays them from exchange proceeds, the effect is to hand the taxpayer additional cash, which may be boot. Coordinate with the lender and the QI on which party pays them.
Do prorated property tax credits cause boot?
Generally, no. Property taxes are prorated between buyer and seller at closing, with the seller credited for taxes already paid. That proration is a settlement adjustment, not a separate cost the buyer pays. One thing to watch: if the preliminary title report shows taxes in arrears and the buyer agrees to pay them, that can be characterized differently. Review the settlement statement carefully and raise any unusual tax items with the title company.
How should advisors coordinate with escrow and title?
Request the preliminary HUD-1 or ALTA settlement statement at least five business days before closing and review it with the QI. Flag any line items that could be read two ways, such as repair credits, owner's policy costs, or endorsements. Then give the escrow officer written instructions on how to handle specific costs, with language like: "Costs related to the 1031 exchange (QI fees, exchange counsel fees, recording fees) shall be paid from the exchange proceeds. Costs related to financing (lender fees, points) shall be paid by the borrower directly."
What's the safest approach to handling repair credits?
Repair credits, which are concessions from the seller for property defects, are tricky. Applied as a reduction to the purchase price, a credit lowers the property's cost basis and raises no boot issue. Applied as a separate "repairs" line item with cash to the buyer, it can be boot. Coordinate with the seller's agent, the title company, and the QI. The cleanest path is to negotiate the purchase agreement so the credit shows up as a lower purchase price rather than a separate payment.
Should the advisor get a copy of the settlement statement before closing?
Yes. Request the preliminary settlement statement (HUD-1 or ALTA) from title at least five business days before closing, and share it with the QI and the client. Review it for line items that could trigger boot or create confusion, and if something looks off, contact the title company and escrow officer to resolve it before closing day. Last-minute surprises are the enemy of a clean exchange.