Print This Article

Expenses and Transaction Costs
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.

Exchange expenses reduce the amount of boot otherwise received in an exchange. Excess exchange expenses, if any, reduce realized gain and thereby increase the basis in the replacement property. See Instructions to lines 15 and 18 of Form 8824. Exchange expenses are amounts charged to the taxpayer for selling expenses (commissions, legal fees, transfer tax, escrow fees, etc.), acquisition expenses (title insurance, finder’s fees, escrow fees, termite report, etc.) and other exchange expenses (intermediary fees, exchange escrow fees, legal and tax fees, etc.). Exchange expenses paid by the taxpayer that relate to the disposition of the relinquished property, the acquisition of the replacement property or the exchange itself reduce the realized gain and recognized gain of the taxpayer and increase the tax basis of the replacement property. See Rev. Rul. 72-456, 1972-2 CB 468; Mercantile Trust Co. of Baltimore v. Commissioner, 32 B.T.A. 82 (1935); PLR 8328011.

For example, if the taxpayer receives $10,000 cash in the exchange but applies $8,000 against the brokerage commission, the taxpayer will recognize only $2,000 of taxable income from the receipt of the cash. In addition to brokerage commissions, other transactional costs should be deductible if “paid out in connection with the exchange.” See PLR 8328011 (allowing “exchange expenses” to offset boot). These transaction costs are referred to as “exchange expenses” in the Instructions to Form 8824. Such costs are not specifically defined anywhere but should include selling expenses that are deducted in computing the amount realized on a sale, purchase expenses that are added to the basis of property, and other costs of implementing an exchange, such as attorney, intermediary and exchange escrow fees.

Example: The relinquished property has a FMV of $2,000,000, adjusted tax basis of $600,000, and gain of $1,400,000 ($2,000,000 less $600,000), ignoring transaction costs. The taxpayer exchanges the relinquished property for replacement property with a FMV of $3,000,000 and thus trades up in value. In the exchange, the taxpayer’s equity is reduced from $800,000 on the old property ($2,000,000 less $1,200,000 debt) to $620,000 on the new property ($3,000,000 less $2,380,000 debt). The taxpayer incurred and paid $190,000 in transaction costs. The question is whether the taxpayer recognizes any gain on this exchange. Does the fact that the taxpayer’s equity was reduced by $180,000 mean that the taxpayer must recognize gain of $180,000? The answer depends on how transaction costs are treated in computing gain recognized in an exchange. In the above example, $190,000 was paid by the taxpayer for transaction costs. The transaction costs exceed the reduction in equity by $10,000 ($190,000 less $180,000). Thus, the taxpayer paid additional cash or gave other consideration to account for this net credit of $10,000. In effect, $10,000 in cash was added to the exchange and used to pay the remaining $10,000 in transaction costs.

In this example, the taxpayer received no cash or other property not of like kind in this exchange on a net basis after taking into account transaction costs. Rather, the taxpayer added $10,000 to the exchange and used $180,000 of equity from the old property to pay the $190,000 in transaction costs. The common sense answer to the above question is that the taxpayer should not recognize any gain on this exchange. The taxpayer did not exit the exchange transaction with $180,000 in cash to do with as he pleased. He simply paid transaction costs to his realtor, attorney, and exchange intermediary and title and escrow fees. Of course, if the transaction costs were only $80,000 in the above example and the taxpayer exited the exchange with $100,000 in his pocket, he should recognize gain of $100,000 in that case.

Accordingly, if and to the extent that the taxpayer uses exchange equity to pay transaction costs, the taxpayer receives no taxable boot on a net basis. The items are a “wash” for tax purposes (the boot received as a result of the charge to equity is offset by the boot paid for the transaction costs). However, as noted in Part III above, to the extent that exchange equity is used to pay proration and other items, the taxpayer may receive taxable boot on a net basis. In the case of transaction costs, money is paid out to other parties in connection with an exchange; in the case of proration and other items, money is effectively paid to and retained by the taxpayer. Further, transaction costs reduce the gain realized in an exchange, while prorations and other items do not affect the amount of gain realized. This treatment of transaction costs applies to all “exchange expenses” paid out in connection with an exchange. See PLR 8328011 and the Instructions to Form 8824. See also Rev. Rul. 72-456, 1972-C.B. 468 (which specifically addresses brokerage commissions paid out in an exchange).

Form 8824 Computations for Above Example
Check on gain:
Value of old property			$2,000,000
Adjusted basis			(1,400,000)
Transaction Costs			(190,000)
Gain Realized			$1,210,000
Check on basis:
Value of new property			$3,000,000
Deferred gain			(1,210,000)
Basis of new property			$1,790,000
Line			Amount	Notes
15	Cash or other boot received		NONE	(1)
16	FMV of like-kind property		$3,000,000
17	Add lines 15 and 16		3,000,000
18	Adjusted basis plus net boot given		1,790,000	(2)
19	Realized gain (line 17 less line 18)		1,210,000
20	Total recognized gain		1,210,000
21	Ordinary income under recapture rules (enter here and on Form 4797, line 16)		NONE	(3)
22	Remaining gain (line 20 less line 21) (enter here and on Schedule D or Form 4797,unless the installment method applies)		NONE	(4)
23	Recognized gain (add lines 21 and 22)		NONE
24	Deferred gain (line 23 less line 19)		1,210,000
25	Basis of like-kind property		1,790,000

Notes

(1) The instructions to line 15 of Form 8824 state that the sum of the following is included on line 15:

(i) any cash paid to the taxpayer by the other party;

(ii) the fair market value of any other (non-like-kind) property received by the taxpayer; and

(iii) any net liabilities assumed by the other party - the excess, if any, of liabilities assumed by the other party on the old property over the total of: (a) any liabilities assumed by the taxpayer on the new property, (b) cash paid by the taxpayer to the other party, and (c) the FMV of any other (not like-kind) property given up by the taxpayer.

None of these boot items were received by the taxpayer here, so zero is entered on line 15.

(2) The instructions to line 18 of Form 8824 state that the sum of the following is included on line 18:

(i) the adjusted basis of the old property;

(ii) exchange expenses, if any (except for expenses used to reduce the amount reported on line 15); and

(iii) net amount paid to the other party - the excess, if any, of the total of: (a) liabilities assumed by the taxpayer on the new property, (b) cash paid by the taxpayer to the other party, and (c) the FMV of any other (not like-kind) property given up by the taxpayer, over liabilities assumed by the other party on the old property.

In this case, there were $190,000 in exchange expenses and $180,000 was used to reduce the amount on line 15. Accordingly, the net exchange expenses (or net cash paid) that was not used to reduce the amount on line 15 was $10,000. The computation for line 18 in the example is as follows:

(3) These calculations assume that there is no depreciation recapture under Sections 1245, 1250, 1252, 1254 or 1255.

(i) For Section 1245 property (generally consisting of tangible depreciable personal property and certain land improvements), the amount of any recapture under Section 1245 to enter on line 21 will be the smaller of (a) the total depreciation deductions allowable (up to the amount of the realized gain on line 19) or (b) any gain shown on line 20 plus the FMV of non-section 1245 like-kind property received in the exchange. See Section 1245(b)(4) and Reg. §1.1245-4(d).

(ii) For Section 1250 property (generally commercial and residential buildings), the amount of any recapture under Section 1250 to enter on line 21 will be the larger of (a) the excess, if any, of the gain that would be reported as ordinary income because of any additional depreciation (depreciation in excess of straight-line depreciation) over the FMV of the Section 1250 property received or (b) any gain shown on line 20. See Section 1250(d)(4) and Reg. §1.1250-3(d).

 

(4) If the installment method applies to the exchange, Section 453(f)(6) is applied to determine the installment sale income taxable for the year and the income is reported on Form 6252. See also Reg. Section 1.1031(k)-1(j)(2). Section 453(f)(6) provides that if a taxpayer received an installment note in a §1031 exchange, the income reported under the installment method is determined as follows:

(i) the total contract price is reduced by the amount of like-kind property received;

(ii) the gross profit is reduced by gain not recognized because of the exchange; and

(iii) the like-kind property received is not considered a “payment.”

Back to Topics