How are selling expenses treated in a section 1031 exchange?
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Selling expenses in a section 1031 exchange are generally treated as reductions to the amount realized on the disposition of the relinquished property, and they also affect the calculation of recognized gain and the basis of the replacement property. The treatment of these expenses is supported by both IRS guidance and Treasury Regulations, and the rules are as follows:
1. Selling Expenses Reduce Amount Realized
When a taxpayer disposes of property, the "amount realized" is the total of all money received plus the fair market value of any property received, reduced by selling expenses. This is a general rule for sales and exchanges, including section 1031 exchanges.
In the context of a section 1031 exchange, selling expenses (also referred to as "exchange expenses" or "transactional expenses") include items such as brokerage commissions, attorney fees, deed preparation fees, and other closing costs directly related to the disposition of the relinquished property.
Example:
If you exchange property with a fair market value of $100,000 and pay $5,000 in selling expenses, your amount realized is $95,000, not $100,000.
2. Effect on Recognized Gain in Partially Taxable Exchanges
If you receive "boot" (money or non-like-kind property) in addition to like-kind property, you must recognize gain to the extent of the net boot received. Selling expenses reduce the amount of boot for this purpose.
Calculation:
Recognized gain is the lesser of: The gain realized, or The net amount of money and non-like-kind property received (boot), after subtracting selling expenses.
Example:
If you receive $10,000 in cash (boot) and pay $5,000 in selling expenses, only $5,000 is considered for recognized gain.
3. Effect on Basis of Replacement Property
The basis of the replacement property is generally calculated as follows:- Start with the adjusted basis of the relinquished property,- Subtract any money received,- Add any gain recognized,- Add selling (exchange) expenses paid.
This is confirmed by both IRS guidance and case law.
Example:
If your relinquished property has a basis of $50,000, you receive $10,000 in cash, recognize $5,000 of gain, and pay $5,000 in selling expenses, your basis in the replacement property is:$50,000 (basis) - $10,000 (cash received) + $5,000 (gain recognized) + $5,000 (selling expenses) = $50,000.
4. Regulatory and Ruling Support
- Treas. Reg. § 1.1031(d)-1(c): The basis of the property transferred, decreased by money received and increased by gain recognized, is allocated to the replacement property. Selling expenses are added to the basis of the replacement property.
- Rev. Rul. 72-456: Provides explicit examples showing that brokerage commissions and other selling expenses reduce the amount realized, reduce recognized gain, and are added to the basis of the replacement property.
- Publication 544: Confirms that exchange expenses reduce the amount realized and are added to the basis of the replacement property.
5. Definition of Transactional Expenses
Transactional expenses are defined in Treas. Reg. § 1.468B-6(b)(4) as those items that are usual and customary in connection with a deferred exchange, such as commissions, prorated taxes, recording or transfer taxes, and title company fees. These are treated as exchange expenses for purposes of section 1031.
6. Special Note on Payment from Exchange Funds
If selling expenses are paid from exchange funds held by a qualified intermediary or escrow, the regulations treat these payments as first paid to the taxpayer and then paid by the taxpayer to the recipient. This ensures the expenses are properly accounted for in the exchange.
Summary: Selling expenses in a section 1031 exchange reduce the amount realized on the disposition of the relinquished property, reduce the amount of recognized gain when boot is received, and are added to the basis of the replacement property. This treatment is supported by IRS rulings, Treasury Regulations, and IRS publications.
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