The general rule when it comes to 1031 exchanges is that all proceeds from the sale must be reinvested in the replacement property, but as a property investor you likely have experience with the other costs associated with closing on a sale, including your real estate agent's commission, the recording of the deed, and know that some of your proceeds must be put towards these sorts of transactional expenses.

But what about expenses that don't necessarily fit into your typical closing statement, a classic example of which being rent proration and security deposits on the sale of a relinquished property?

The proper way to deal with these situations is to write a check covering the remaining rent and security deposit to the purchaser, taking the money out of your operating account. Some investors, however have tried to debit these kinds of expenses to the closing statement. This is inappropriate and subverts the premise of section 1031 of U.S. tax code.

In the process of a 1031 exchange, you will also face expenses related to the acquisition of new debt on your replacement property. Loan origination fees, underwriting fees, and processing fees are not part of a like-kind exchange and the money must come out of your own property.

The message you should take away from this article is that it is best to simply pay these kinds of expenses out of your own account rather than making a risky attempt to walk out of a 1031 exchange with extra cash in your pocket. The IRS has pursued litigation against investors who have tried these kinds of tactics, one notable example being the case of the Commissioner v. Garcia.