Closing Costs in a §1031 Exchange: A Trap for the Unwary?

Closing statements are replete with prorations and credits that adjust the sales price.  Other line items reflect the payment of recording fees, title insurance and other transaction expenses.   Seemingly routine, the way these expenses are handled in a §1031 exchange may have unintended tax consequences.

Remember that the rationale for tax-deferral under §1031 is that the taxpayer has merely moved his investment from one property to another.  The form may have changed, but as long as the underlying investment remains unchanged no tax is due.  Any “cashing out” of the investment (i.e. reduction in equity) will be taxed.

In some instances, using exchange funds to pay closing costs or issue credits that adjust the price, may be a form of cashing out.  The result is that the transaction may be partially taxable.
Another concern is that paying certain expenses could be construed as impermissible receipt of the exchange funds.  Under the IRS regulations the taxpayer cannot have actual or constructive receipt of the exchange funds.  Improper receipt could cause the entire exchange to fail.
The IRS and case law provide very little guidance on this topic.  This article discusses the issues in general, but because of their uncertainties and technical nature, it is important that every taxpayer have his tax advisor approve each closing statement, so there are no surprises when preparing the tax return.

EXCHANGE EXPENSES

Certain items paid at a closing are considered “Exchange Expenses”.  Using exchange funds to pay those expenses will not result in a tax liability to an investor doing a §1031 exchange.  For example, Revenue Ruling 72-456 provides that if exchange funds are used to pay brokerage commissions, it does not result in the transaction being partially taxable.  There are no other clear rulings on this subject, but most tax advisors agree that the following expenses are exchange expenses and may be paid at the closing of the relinquished or replacement properties without any tax consequence:
• Brokerage commissions • Exchange fees • Title insurance fees for the owner’s policy of title insurance • Escrow fees • Appraisal fees required by the purchase contract • Transfer taxes • Recording fees  • Attorney’s fees incurred in connection with the sale or purchase of the property

NON-EXCHANGE EXPENSES

Not all expenses are Exchange Expenses.  Exchange funds can be used to pay a non-exchange expense, although doing so may result in the exchange being partially taxable.
Such payments will not invalidate the application of the Qualified Intermediary safe harbor, but they may still constitute boot to the Exchanger.  On a typical settlement statement the seller of the relinquished property will give the buyer a credit against the sales price, representing security deposits and prorated rents.  Effectively, the seller was using exchange funds to pay the security deposit and prorated rent amounts to the buyer.  To avoid a taxable event, the seller should deposit his own funds to pay those security deposits and prorated rents to the buyer, rather than giving a credit.
In addition, most tax advisors believe that fees and costs paid in connection with getting a loan to acquire the replacement property should be considered costs of obtaining the loan, not costs of acquiring the replacement property, and thus are not Exchange Expenses.  To avoid any potential tax liability, the buyer may want to deposit his own funds to pay loan related expenses.
Some non-exchange expenses create a tax liability but are offset by a deduction.  One example of this is property taxes.  Although property taxes are not an Exchange Expense, the investor will get a deduction for paying the property taxes, and that liability will be offset by a deduction.
The following items are typically found on a closing statement but are generally not considered Exchange Expenses because they do not relate directly to the disposition of the relinquished property or the acquisition of the replacement property:
• Loan costs and fees • Title insurance fees for the lender’s title insurance policy • Appraisal and environmental investigation costs that are required by the lender • Security deposits • Prorated rents • Insurance premiums • Property taxes

TRANSACTIONAL ITEMS AND CONSTRUCTIVE RECEIPT

A separate, but important, issue is whether paying a non-exchange expense from exchange funds will be construed as constructive receipt of those funds by the investor, which has the potential to disqualify the entire exchange.  Under the IRS Regulations exchange funds can be used to pay “transactional items that relate to the disposition of the relinquished property or to the acquisition of the replacement property and appear under local standards in the typical closing statement as the responsibility of a buyer or seller (e.g., commissions, prorated taxes, recording or transfer taxes, and title company fees).”
For example, an investor may want to use exchange funds to pay a rate lock-in fee to a lender.  Since these fees by their nature are paid before the closing, and are not strictly required for the acquisition of the replacement property, paying the fee from exchange funds may trigger a constructive receipt problem.
Since there is no clear IRS guidance, it is important that investors discuss the issue with their tax advisors before seeking to use exchange funds to pay non-exchange expenses, whether prior to, or at the replacement property closing.

 

REFERENCES

Revenue Ruling 72-456; TAM 8328011; Treasury Regulation §§ 1.1031(k)-1(g)(6) and (7); IRS Form 8824.  – See more at: http://firstexchange.com/July2013Newsletter

-from First American Exchange Company July 2013 Exchange Update

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FHA Streamline Refinancing Fees Reduced

The White House recently announced significant changes that will reduce the fees charged for the Federal Housing Administration‘s (FHA) Streamline Refinance Program.

Beginning June 11, 2012, the Streamline Refinance upfront fee of 1% will be reduced to 0.01% of the total loan amount. And the annual fee will be lowered from 1.15% to 0.55% of the total loan amount.

By refinancing through this streamlined process, the average qualified FHA-insured borrower will save approximately $3,000 a year or $250 per month, on top of any savings from refinancing to a lower mortgage rate.

The “streamline” refers to the minimal amount of documentation and underwriting that needs to be performed. Streamline refinancing can be done without an appraisal or income verification, providing the person(s) on the loan hasn’t changed.

There are no loan-to-value (LTV) restrictions on streamline refinancing. This is significant for underwater borrowers whose loan amount may exceed the current value of their home. However, second liens must subordinate with a maximum combined LTV ratio of 115% based on the original appraised value of the property.

The basic requirements of a streamline refinance are:

  • The loan must already be FHA insured and endorsed on or before May 31, 2009.
  • Borrowers must be current on their mortgage payments with no late payment in the previous 12 months.
  • The refinance must result in a lowering of the borrower’s monthly principal and interest payments.

Currently, 3.4 million households with loans endorsed on or before May 31, 2009, pay more than a 5% annual interest rate on their FHA-insured mortgages.

from Prospect Mortgage Industry Insider

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FHA Insurance Premiums Will Increase Soon

If your clients are considering buying or refinancing a home, you should let them know that the Federal Housing Administration (FHA) will soon increase mortgage insurance premiums on FHA home loans.

The Department of Housing and Urban Development (HUD) announced it would increase the annual mortgage insurance premium (MIP) by 0.10% for FHA loans under $625,500. This would raise the fee from 1.15% to 1.25% of the total loan amount. This annual premium increase — which is broken down into monthly payments — takes effect April 1, 2012.

In addition, HUD announced it would raise the FHA’s upfront annual mortgage insurance premium (UFMIP) from 1% to 1.75% effective April 1, 2012.

Starting June 1, 2012, the MIP for FHA loans over $625,500 will increase 0.35%, raising that fee to 1.50% of the total loan amount.

The primary reason for the changes is to bolster capital reserves for FHA’s Mutual Mortgage Insurance Fund. Congress has mandated the fund keep 2% in reserves. Last year, that reserve had slipped to 0.2%. The changes are expected to generate about $1 billion annually for the fund.

The increase in mortgage insurance costs applies to the purchase or refinancing of all FHA loans regardless of the amortization term or loan-to-value (LTV) ratio. The increases will not apply to borrowers already in an FHA-insured mortgage, a Home Equity Conversion Mortgage (HECM), and other special loan programs to be outlined in a forthcoming FHA Mortgagee Letter.

For your customers considering refinancing or making a purchase, they might want to act before the new mortgage insurance premiums take effect.

from Prospect Mortgage Industry Insider

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FHA will keep funding flips

For the second year in a row, the Federal Housing Administration is extending a temporary waiver of its “anti-flipping” rule, meaning homebuyers relying on FHA-insured financing will continue to be able to buy homes that have changed hands in the last 90 days.

The waiver is a boon for investors seeking to rehab and flip properties, because it expands the pool of eligible borrowers to include those relying on FHA-backed loans, popular with first-time homebuyers and others who lack the cash to make large down payments.

In extending the waiver through 2012, FHA said all transactions must continue to be arms-length. In cases in which the sales price of the property is 20 percent or more above the seller’s acquisition cost, the waiver will apply only if the lender can document the justification for the increase in value, FHA said.

FHA instituted the anti-flipping rule in 2003 to protect its mutual mortgage insurance program from losses on homes that were merely flipped, rather than rehabbed. Homes repossessed by Fannie Mae, Freddie Mac, and state- and federally chartered financial institutions were exempt from the rule.

In February 2010, the Obama administration waived the waiting period for resales — including homes purchased and rehabbed by private investors — in the hopes of stabilizing home prices and revitalizing communities hit by foreclosures.

It often takes less than 90 days to acquire, rehabilitate and sell properties, the Department of Housing and Urban Development said at the time. Some sellers of rehabbed properties had been reluctant to enter into contracts with FHA buyers because of the cost of holding a property for 90 days, HUD said.

In extending the waiver through 2011, FHA said it insured 21,000 90-day property flip loans worth more than $3.6 billion in 2010 that would otherwise not have qualified for financing.

That number has since grown to nearly 42,000 mortgages worth more than $7 billion on properties resold within 90 days of acquisition.

By Inman News, Wednesday, December 28, 2011.

Inman News®

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FHA will keep funding flips

For the second year in a row, the Federal Housing Administration is extending a temporary waiver of its “anti-flipping” rule, meaning homebuyers relying on FHA-insured financing will continue to be able to buy homes that have changed hands in the last 90 days.

The waiver is a boon for investors seeking to rehab and flip properties, because it expands the pool of eligible borrowers to include those relying on FHA-backed loans, popular with first-time homebuyers and others who lack the cash to make large down payments.

In extending the waiver through 2012, FHA said all transactions must continue to be arms-length. In cases in which the sales price of the property is 20 percent or more above the seller’s acquisition cost, the waiver will apply only if the lender can document the justification for the increase in value, FHA said.

FHA instituted the anti-flipping rule in 2003 to protect its mutual mortgage insurance program from losses on homes that were merely flipped, rather than rehabbed. Homes repossessed by Fannie Mae, Freddie Mac, and state- and federally chartered financial institutions were exempt from the rule.

In February 2010, the Obama administration waived the waiting period for resales — including homes purchased and rehabbed by private investors — in the hopes of stabilizing home prices and revitalizing communities hit by foreclosures.

It often takes less than 90 days to acquire, rehabilitate and sell properties, the Department of Housing and Urban Development said at the time. Some sellers of rehabbed properties had been reluctant to enter into contracts with FHA buyers because of the cost of holding a property for 90 days, HUD said.

In extending the waiver through 2011, FHA said it insured 21,000 90-day property flip loans worth more than $3.6 billion in 2010 that would otherwise not have qualified for financing.

That number has since grown to nearly 42,000 mortgages worth more than $7 billion on properties resold within 90 days of acquisition.

By Inman News, Wednesday, December 28, 2011.

Inman News®

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Renter’s Insurance

Take a look around you. Everything you see has value, and you could be vulnerable if you don’t have insurance.  Many renters think that their possessions are covered by their landlord’s policy. But your landlord’s policy typically only covers the structure and any liabilities the owner would face. Your possessions are not covered under this type of policy.

Why Do You Need Insurance?

You may think your possessions aren’t valuable enough to insure, but add up the cost of replacing everything you have. It is a significant amount of money. If you do not have enough savings to cover these expenses all at once, you need renter’s insurance. Many policies also provide personal liability coverage, protecting you in the event that someone is injured at your home.

Isn’t It Expensive?

Renter’s insurance can cost as little as $15.00 a month. It all depends on how much coverage you want and where you live. Considering that you have no control over circumstances like fire, water damage, or burglary, this is a wise investment and gives you peace of mind.

Where Do I Get Renter’s Insurance?

Almost all insurance agents that sell homeowner’s insurance also sell renter’s insurance. Call several for quotes and choose the one that seems the most comprehensive and affordable for you. If you are interested in buying renter’s insurance online, search for renter’s insurance and you will find many companies willing to give you quotes by email. One company specializes in renter’s insurance with a low deductible and the ability to purchase your policy online. Go to renterscoverage. com for more information. 

from Puliz Records Management September 2011 Newsletter “Bits and Pieces”

 

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