A 1031 Exchange is a type of commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the sale proceeds into another property that is considered to be “like kind.” Clearly this is a tremendous tax benefit, but it is a complicated transaction that requires the assistance of multiple parties, none of whom work for free.
In this article, we are going to describe the fees and transaction costs involved in a typical 1031 Exchange. We will describe what they are, how much they cost, and how these costs can impact the Exchange transaction. By the end, readers will have the information needed to determine if a 1031 Exchange Transaction is a suitable fit for their own unique financial circumstances.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. In the course of our normal business, we frequently assist investors with the placement of their 1031 Exchange funds. If you are an Accredited Investor looking to complete a 1031 Exchange and would like to learn more about our current investment opportunities, click here.
How Does a 1031 Exchange Work?
In order to understand the costs involved in a 1031 Exchange, it is first helpful for real estate investors to understand how the exchange process works. It should be noted that the specific rules for a 1031 Exchange are described in section 1031 of the Internal Revenue Code. They are summarized in this section for the sake of simplicity.
The first step in a 1031 Exchange is for an investor to recognize that they have a taxable gain on a property that is held for investment. Next, they put the property up for sale and when it is sold, the clock starts ticking.
Within 45 days of the sale of the “relinquished property”, the investor must identify, in writing, one or more “replacement properties” that they plan to buy. Within 180 days of the sale date, they must close on the purchase of their identified replacement properties. In addition, the market value and equity in the replacement property must be the same or more than the relinquished property.
If an investor/taxpayer violates any of the 1031 Exchange rules, as defined by the IRS, it could trigger a taxable event that would cause some or all of the gain to be subject to capital gains taxes.
What is a Qualified Intermediary?
Because a 1031 Exchange can be a complex transaction, it requires some assistance from outside parties to make sure all of the rules are followed. Usually these outside parties include a tax advisor/attorney, CPA, and/or a Qualified Intermediary. Together, these individuals and firms work together to assist the investor in their completion of the 1031 Exchange transaction and to make sure that all of the rules are followed.
They do not work for free.
So, How Much Does a 1031 Exchange Cost – In Fees?
It can be difficult to make a blanket statement about how much a 1031 Exchange costs because every transaction is unique, and there several types of 1031 Exchanges – including the traditional delayed exchange, the reverse 1031 exchange, and the construction exchange. So, the cost can vary based on the type of exchange, the Qualified Intermediary’s fee structure, and a number of other factors that can impact the cost.
But, as a general rule, the total cost of a 1031 Exchange typically ranges from $500 – $1,500 or more. This cost can be broken down into a number of specific fees, which are detailed below.
Qualified Intermediary Fees
As described above, a Qualified Intermediary, sometimes called an exchange accommodator, is a firm that is an expert in 1031 Exchange rules and they do a significant amount of work to facilitate the transaction. Generally, there are two types of Qualified Intermediaries, Institutional which is affiliated with a bank or title company or non-institutional.
An institutional Qualified Intermediary can charge from $800 – $1,200 per transaction while a non-institutional QI typically charges in the range of $600 – $800.
Set Up Fees and Administrative Fees
The Qualified Intermediary fees described in the previous section, are charged to fund the set up and administrative costs of completing a 1031 Exchange. These fees cover the cost associated with preparing the necessary legal documents and processing them, and notarizing them. In addition, there may be some cost for delivering them and receiving them back.
The cost of these fees is included in the $600 – $1200 range described above.
Per Property Fees
The fees described above assume that there is only one property included in the exchange. While this is the most common scenario, there are scenarios where multiple properties are processed as part of the exchange. When this is the case, there is a charge for each additional property that is usually in the $300 – $500 range.
Interest Income Earned and Retained
When the relinquished property is sold, it is common for the sales proceeds to be placed into escrow by the Qualified Intermediary and these funds may earn interest in the up to 180 day period before the purchase of the replacement property is consummated. So, some portion of the interest income earned may be retained by the Qualified Intermediary as part of their fee.
Allowable Closing Costs on 1031 Exchanges
In addition to the transaction and service fees described above that are related specifically to completing the exchange with the Qualified Intermediary, there are a number of other fees that are common in any commercial real estate transaction. A brief description of each is below.
As part of the due diligence process, many lenders require an appraisal to be completed by an independent third party. Appraisal fees can vary, but they can cost up to $5,000 or more depending on the property type and size.
There are a lot of contracts, loan agreements, and paperwork that must be prepared and/or reviewed by a real estate attorney. Typically, attorneys charge by the hour and their total fee can easily reach into the thousands of dollars, depending on the complexity of the transaction.
Brokers can earn money on both sides of the transaction. They can earn a commission on the sale of the relinquished property when they represent the seller. It is usually 4% – 8% of the property’s value, which they may have to split with another broker.
A broker can also earn a commission on the purchase of the new property if they represent the buyer, and this is typically paid by the seller at the time of closing.
In some cases, the broker could be the same person on both the sell side and the buy side, which can be very lucrative for them.
There may be fees associated with holding or placing money in escrow until the purchase of the new, like kind property is complete. Escrow fees can reach up to 2% of the property’s value.
Excise / Transfer Taxes
There are fees that are charged by cities and counties to complete the legal transfer of a property from one individual or entity to another. The fees can vary widely by municipality, but usually range from 1% to 3% of the total value of the deal.
Of course, before buying any property the individual will want to ensure that it is in good condition and that there are no major surprise repair bills. The cost of an inspection is highly dependent upon the size of the property, but they can easily run into the thousands of dollars for larger commercial properties.
Property taxes must be paid each year, but not all purchase and sale transactions close on the first of the year. So, it is common for investors to pay the pro rata amount of property taxes that will be due for the portion of the year that they own the property. The amount is highly dependent on the value of the property, but they can also be several thousand dollars.
Counties and municipalities charge fees for the recording of the transaction in their records. Usually, there are several hundred dollars, but these fees can vary widely.
As part of the normal transactional costs, buyers typically must pay for title insurance in case there is any issue with the title to the property. The cost is usually around 1% of the sales price.
Loan Acquisition Fees
There are fees associated with obtaining debt financing for the purchase of a property. For example, there may be origination fees or fees charged by a loan broker. These are usually around .5% – 1% of the amount being borrowed.
It may be possible for each of the fees described above to be paid from the proceeds of the sale of the replacement property without creating a taxable event. However, there is another group of fees that may not qualify for the same tax treatment. They are described in the next section.
Non-Qualified Exchange Fees
As the name suggests, an attempt to pay for a “Non-Qualified” fee from the exchange proceeds of the relinquished property may create a taxable event, which means that capital gains taxes could be assessed on the funds used. Some examples of non-qualifying exchange fees are described below.
There may be fees associated with completing an application for a loan or 1031 Exchange. The fee is usually around $100.
Mortgage Lender Appraisal
Although not the norm, it is possible that two appraisals will need to be completed to settle a 1031 Exchange. One could be required by the investor, while a lender could require an additional appraisal. Typically, these are combined into one appraisal, but the one for the lender may be a non-qualifying fee and can cost up to $1,000.
Not all investors opt to get new debt in a 1031 Exchange. In some cases, they could “assume” the current debt on the property from the seller, In such cases, they may be required to pay assumption fees to the lender of no more than 1% of the outstanding loan balance.
Nearly all lenders require the completion of a Phase 1 Environmental report to ensure there are no known contaminants in the groundwater. These reports can take weeks to produce and can cost $2,500 – $5,000 depending on the complexity of the assignment. If the Phase 1 finds evidence of contaminants, it may be necessary to complete a more detailed Phase 2, which can add additional cost.
If there are any referral fees that must be paid to middlemen, like brokers or deal finders, they are non-qualifying and can run from 5% to 30% of the total value of the deal.
Lender’s Title Insurance
Much like an appraisal, lenders may require the buyer to purchase lender’s title insurance. This protects the lender’s interest in the deal in case there are any issues with the property’s title. The typical fee is around .5% of the purchase price.
Mortgage Protection Insurance
Mortgage protection insurance protects lenders from financial loss in the event that the borrower does not repay their loan as agreed. These premiums are typically paid up front and could cost 1% – 2% of the loan amount.
Loan Reserve Amounts
Once the loan is closed, investors may be required to maintain a certain amount of liquid capital (cash, money market, or stocks and bonds) that is equal to some number of loan payments. The exact number is specified by the lender, but can be equal to up to 12 months of payments.
Some borrowers may be able to buy down their interest rate by pre-paying for “points” where each point is equal to 1% of the loan amount. Discount points are paid up front and can account for a significant portion of the closing costs.
Property Liability Insurance
Most lenders require some sort of property liability insurance that protects against financial loss in the case of an unforeseen event like a flood or fire. Depending on the size of the exchange property, the premium for the insurance policy can be $2,000 or higher and is usually paid up front.
Like property taxes, it may be possible that an exchange participant may have to pay some amount of prorated rent, depending on the day of the month that the transaction closes. The exact amount depends on the rent due for the space, but it is usually paid as part of the closing costs.
If an exchange participant rents space in the property involved in the transaction, they may have to pay a security deposit when signing a new lease. The exact amount of the deposit can vary, but it is usually equivalent to at least one month’s worth of rent and is paid up front.
1031 Exchange Costs and Real Estate Syndications
A 1031 Exchange is a complicated transaction and the hardest part of this unique real estate investment opportunity is finding a suitable replacement property within the relatively short time frame allowed. A syndication, like the type we offer, can provide a compelling alternative to the “go it alone” approach of an individual investor. In it, investors purchase a fractional share of an institutional grade investment property as the replacement property in a 1031 like kind exchange. Once the transaction is complete, the investor receives passive income while the syndicator does the hard work of managing the asset.
In other words, this option provides investors with all of the benefits of commercial real estate ownership without the hassle of managing it.
Summary of 1031 Exchange Costs
In a 1031 Exchange, an investor is able to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the proceeds into another like kind property.
To complete this transaction, there are a number of fees that investors must pay to facilitate the deal closing. Generally, they fall into two categories, qualifying and non-qualifying.
Qualifying fees can be paid from exchange proceeds without creating a taxable event and they typically include those paid to a Qualified Intermediary for their exchange services as well as transfer taxes, broker commissions, and recording fees.
Non-qualifying fees cannot be paid from exchange proceeds without creating a taxable event, and they include things like environmental reports and the lender’s appraisal.
Instead of finding a replacement property on their own, some investors may choose to purchase a fractional share of an institutional grade property through a syndication. It provides all of the benefits of commercial real estate ownership without the hassle of managing the property.
Interested In Learning More?
First National Realty Partners is one of the leading private equity commercial real estate investment firms in the United States. We leverage decades of expertise to find world-class, multi-tenanted assets available below intrinsic value. We seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our investment opportunities, contact FNRP at (800) 605-4966 or firstname.lastname@example.org.