In a 1031 exchange, qualified expenses are the transactional costs of selling the relinquished property or completing the exchange itself — brokerage commissions, qualified intermediary fees, title insurance premiums, government transfer taxes, escrow and settlement fees, recording and notary charges, and legal fees tied specifically to the exchange. Paid from exchange proceeds, these costs reduce your recognized gain and can lift the basis of the replacement property. Loan-related costs, prorated property taxes, hazard insurance premiums, rent and deposit prorations, and inspection or warranty fees are not qualified, and paying them out of exchange funds creates taxable boot.
What Counts as a Qualified Exchange Expense
The category is narrower than most sellers assume. A cost qualifies when it is directly tied to transferring the relinquished property or executing the exchange mechanism, not to owning or financing the replacement. Revenue Ruling 72-456 established that brokerage commissions paid on the relinquished property offset the cash received when calculating gain, and the same reasoning extends to the other direct transactional costs of the deal.
The costs that consistently qualify:
- Brokerage commissions. Typically the largest single expense in the transaction. The national average runs roughly 5.4% to 5.7% of the sale price combined for listing and buyer’s agents.
- Qualified intermediary fees. The third party holding your exchange funds generally charges between $750 and $1,500 for a standard deferred exchange.
- Title insurance premiums. Paid to insure clear title on the properties in the transaction.
- Government transfer taxes. State and local taxes imposed on the transfer of real property. Rates vary widely by jurisdiction.
- Escrow and settlement fees. Charges from the closing agent for managing the transaction.
- Recording fees and notary costs. Administrative charges for filing the deed and notarizing documents.
- Legal fees. Attorney costs specifically for drafting exchange documents or overseeing the closing.
These expenses work two ways in the exchange math. They reduce the realized gain on the relinquished side, and any amount that exceeds the boot received then increases the tax basis of the replacement property. A higher basis means less taxable gain when you eventually sell for cash. On IRS Form 8824, exchange expenses first reduce the amount on line 15, which calculates boot received; any remaining exchange expenses increase the basis reported on line 18.1Internal Revenue Service. Instructions for Form 8824
One boundary worth flagging: Section 1031 itself only covers real property held for investment or business use. Since the Tax Cuts and Jobs Act of 2017, exchanges of equipment, vehicles, artwork, and other personal property no longer qualify, and your primary residence never qualified.2Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment The expense rules below assume you already have a qualifying real property exchange.
What Doesn’t Qualify and Why It Creates Boot
Costs that aren’t directly tied to the exchange transaction fall outside the qualified category. When exchange proceeds pay for them, the IRS treats that payment as cash diverted to you, and that diversion is taxable boot to the extent you have a realized gain. This is where most taxpayers get tripped up, because several of these costs show up on the same settlement statement as the qualifying ones and feel like part of buying the replacement property.
The main categories that do not qualify:
- Loan-related costs. Application fees, mortgage points, lender-required appraisals, and other charges tied to financing the replacement property. These belong to the loan process, not the exchange process.3American Bar Association. Exchanges Under Code Section 1031
- Prorated property taxes. These are property-specific ownership liabilities, not transactional costs. Using exchange funds to cover them is treated as receiving a cash benefit.
- Hazard insurance premiums. Like property taxes, insurance is an ownership cost rather than an exchange cost.
- Rent prorations and security deposit credits. Adjustments related to ongoing property operations, not to the exchange itself.
- Home warranties and inspection fees. These relate to the property’s condition rather than the exchange transaction.
The classification does not scale with the size of the deal. A $5 million exchange and a $300,000 exchange follow the same rules about which costs qualify. The practical workaround most exchangers use is straightforward: pay the non-qualifying costs out of pocket at closing rather than letting them come out of the escrowed exchange funds. That keeps those amounts from being recharacterized as boot. When cash outside the exchange isn’t available, some exchangers negotiate for the seller to cover certain buyer-side costs, or roll financing charges into the loan itself so they never touch exchange proceeds.
How Misclassified Costs Become a Tax Bill
Boot is anything you receive in the exchange that isn’t like-kind real property, and cash boot is the form that matters for expense categorization. Every dollar of exchange funds spent on a non-qualifying cost is a dollar the IRS treats as received by you. That cash is taxable up to the amount of your realized gain on the relinquished property.
The rate that applies to recognized gain is rarely a single number. Depreciation recapture gets taxed first, at a maximum rate of 25% under the unrecaptured Section 1250 gain rules, up to the amount of depreciation you claimed while holding the relinquished property. Gain beyond the recapture layer falls under long-term capital gains rates of 0%, 15%, or 20%, depending on taxable income. Most investment property owners land in the 15% or 20% bracket.4Internal Revenue Service. Topic No. 409, Capital Gains and Losses
High-income taxpayers add another 3.8% for the Net Investment Income Tax on gains from investment real estate. The surtax applies when modified adjusted gross income exceeds $200,000 for single filers or $250,000 for joint filers, and those thresholds are not indexed for inflation.5Internal Revenue Service. Questions and Answers on the Net Investment Income Tax Stacked together, a high-income exchanger can face up to 28.8% on the depreciation recapture portion of recognized gain and up to 23.8% on the capital gains portion. That is the tax exposure a misclassified $10,000 line item on a settlement statement can trigger.
Documenting Qualified Expenses on Form 8824
Every 1031 exchange gets reported on IRS Form 8824 with your tax return for the year you transferred the relinquished property. The form asks for descriptions of both properties and the key dates, but the arithmetic is where expense categorization pays off or costs you.1Internal Revenue Service. Instructions for Form 8824
Line 15 calculates the boot you received: cash, non-like-kind property, and net debt relief. Qualified exchange expenses reduce that line 15 figure directly, shrinking the taxable portion of the exchange. When exchange expenses exceed the line 15 amount, the leftover adds to your basis on line 18, raising the adjusted basis of the replacement property and reducing gain on a future sale.1Internal Revenue Service. Instructions for Form 8824
The settlement statement from closing is the primary documentation for those numbers. Every line item on it should be categorized as either a qualified exchange expense or a non-qualifying cost, and the totals fed into Form 8824 should match that categorization. Keep the settlement statements and your working schedule indefinitely, not just for the standard three-year audit window. The basis of your replacement property carries forward until you eventually sell or exchange again, and you may need to prove those numbers many years later. Interest and penalties accumulate if the IRS later determines that non-qualifying costs were treated as qualified exchange expenses and the reported basis was inflated as a result.