The IRS stipulates that in order for closing costs to be paid out of exchange funds, the costs must be considered a Normal Transactional Cost. Normal Transactional Costs, or Exchange Expenses, are classified as a reduction of boot and increase in basis, where as a Non Exchange Expense is considered taxable boot.

Some expenses that are expenses of owning property (such as property taxes and insurance) rather than expenses related to the sale or purchase are considered “non-exchange expenses.”  If exchange funds are used to pay non-exchange expenses, the transaction may be partially taxable. 

 An Exchanger should always discuss treatment of closing costs with Your Qualified Intermediary  prior to the respective closing.