Does a 1031 Exchange Avoid Real Estate Transfer Tax?

Usually, no. A 1031 exchange defers federal income tax on the gain from selling investment property, and most states follow that treatment for their own income tax. Real estate transfer tax is a different tax. It is charged by a state, county or city when a deed is recorded or ownership changes hands, and an exchange still involves a deed going to your buyer and a deed coming to you. In most places the transfer tax on each of those closings is due as normal, whoever the contract or local custom says pays it.

Why does a 1031 exchange not cover transfer tax?

Section 1031 is part of the federal income tax code. It changes when you recognise gain for income tax purposes. It says nothing about the separate taxes that state and local governments charge on the transfer of real property itself.

Transfer taxes go by many names, including documentary stamp tax, deed tax, conveyance tax, excise tax and recordation tax. They are normally calculated on the price or the value of the property, and they are collected at closing so the deed can be recorded. Some jurisdictions charge nothing at all. Others layer a state rate, a county rate and a city rate on top of each other, and a few charge higher rates on more expensive property.

From the recorder's point of view, the sale of your relinquished property is an ordinary sale and the purchase of your replacement property is an ordinary purchase. The fact that your Qualified Intermediary is holding the proceeds in between does not usually change that.

Do you pay transfer tax twice because of the Qualified Intermediary?

In a standard forward exchange, normally not. Early exchange structures had the intermediary take title to the property and then pass it on, which could mean two recorded transfers for one sale. The Treasury regulations now allow what is called direct deeding. Your contract rights are assigned to the Qualified Intermediary, but the deed goes straight from you to your buyer, and later straight from the seller of the replacement property to you.

The result is one deed on each side of the exchange, so one transfer tax charge on each side, just as there would be without an exchange. Your Qualified Intermediary and closing agent will set this up, and it is worth confirming that both closings use direct deeding.

Where can transfer tax show up more than once?

Some exchange structures do involve extra transfers, and that is where transfer tax deserves a closer look.

• ›Reverse exchanges. An Exchange Accommodation Titleholder takes title to the parked property and later transfers it to you. Depending on the jurisdiction, that second transfer may be taxed, partly taxed or exempt.
• ›Drop and swap. When a partnership or LLC deeds property out to its members as tenants in common before a sale, that deed can be a taxable transfer in some places.
• ›Transfers of entity interests. Some states tax the sale of a controlling interest in an entity that owns real estate, even though no deed is recorded.
• ›Changing how title is held. Moving property into or out of an LLC or trust around the time of an exchange can create its own transfer, as well as a same taxpayer question.

None of these are reasons to avoid the structure. They are reasons to ask the closing attorney or title company in each jurisdiction what will be charged before you commit.

Can exchange funds be used to pay transfer tax?

Transfer tax on the sale is generally treated as a normal selling cost. Costs of that kind are commonly paid out of the sale proceeds at closing, and many CPAs and intermediaries treat them as reducing the amount realized rather than as cash you received. That generally means paying them from the proceeds does not create boot.

On the replacement side, transfer tax you pay as the buyer is generally treated as part of your cost of acquiring the property. Whether that cost is paid with exchange funds or with your own money, and how it affects your basis, is something your CPA should confirm against the final settlement statement.

The line items to watch are not the transfer taxes themselves, but the things that sometimes travel with them on the same statement, such as loan fees, rent prorations and security deposits. Those are covered in our separate article on settlement statement lines that create boot.

What could transfer tax look like on a typical exchange?

Here is an illustrative example only, with invented numbers. Actual rates vary widely by state, county and city, and some places charge none at all.

• ›Relinquished property sale price: 1,000,000.
• ›Illustrative seller side transfer tax at 1 percent: 10,000, paid at closing from the sale proceeds.
• ›Replacement property purchase price: 1,400,000.
• ›Illustrative buyer side transfer tax at 0.5 percent: 7,000, paid at the replacement closing.

In this example, the exchange may defer income tax on the gain, but 17,000 of transfer tax is still paid across the two closings. If the replacement purchase were structured as a reverse exchange in a place that taxes the transfer out of the accommodation titleholder, the buyer side figure could apply a second time.

The useful habit is to ask for an estimated closing statement on both sides early, with transfer taxes shown, so the number is part of your planning rather than a surprise the week you close.

Is transfer tax the same as property tax reassessment or state withholding?

No. These three are often confused because they all appear around closing.

• ›Transfer tax is a one time charge on the transfer of the deed.
• ›Property tax reassessment is a change to the annual property tax on the replacement property, based on how your state values property after a purchase. A 1031 exchange generally does not prevent reassessment.
• ›State withholding is an advance payment of income tax that some states require from certain sellers, which an exchange may reduce or eliminate if the right forms are filed.

Each is governed by different rules, and each is worth raising with your closing agent and CPA separately.

What about a Delaware Statutory Trust as replacement property?

When a DST is the replacement property, you are acquiring a beneficial interest in a trust rather than taking a deed to a building. Property level acquisition costs are generally handled within the offering and described in the definitive offering documents, so read those costs carefully. DST interests are securities, available only to accredited investors through a licensed broker dealer, and investing carries risk, including loss of principal.

The short version

A 1031 exchange is an income tax deferral. It is not a closing cost waiver. Expect transfer tax on both sides of a standard exchange, ask whether your structure creates any additional transfers, and have your CPA and Qualified Intermediary review the settlement statements before you sign them.