Completing a 1031 exchange after selling an investment property can help real estate investors increase the purchasing power of their investment capital and also defer taxes on any realized capital gains.
Section 1031 of the Internal Revenue Code lays out the rules for completing like-kind exchanges so investors can defer capital gains on the sale of relinquished assets. However, taxation rules can vary from state to state regarding the sale of real property – and one state formerly didn’t even recognize 1031 exchanges.
In this article we’ll take a look at which states don’t recognize 1031 exchanges, as well as some taxation rules investors should consider when exchanging real estate across state lines.
State Mandatory Withholding Collections and Claw-Back Provisions
Many states impose an income tax on the sale of real property assets. This tax, called a state mandatory withholding, is usually collected at close of sale. Collection duties can vary from state to state – some may require the authorized agent facilitating the sale, such as a title or escrow officer, to collect the state mandatory withholding tax. Others may require the buyer to pay the tax at close of sale. Collection amounts and methods to calculate the tax can vary as well. Some states also may offer exemptions for non-residents if their properties are transferred in 1031 exchanges.
Four states – California, Oregon, Montana, and Massachusetts – have what’s known as clawback provisions. These states impose a state tax on any realized gains from the sale of investment properties. They also may require exchangors to file annual returns with the state’s tax authority for as long as they hold the property. These states may exempt taxation on the transaction when it’s part of a 1031 exchange, but if you divest the replacement asset through traditional sale, those four states will seek to recapture state mandatory withholding taxes on deferred gains through clawback provisions.
The Commonwealth of Pennsylvania and 1031 Exchanges
Internal Revenue Code Section 1031 for tax-deferred exchanges is a federal tax code, so technically it’s recognized in all 50 states. That wasn’t true in Pennsylvania, although the Keystone State has enacted legislation for 2023 that brings about some sweeping changes to its tax code as it pertains to 1031 exchanges.
Formerly, investors could complete 1031 exchanges to defer capital gains taxes at the federal level, but they could not defer taxation on any capital gains at the state level. However, House Bill 1342, which was signed into law by Pennsylvania Governor Tom Wolf in July of 2022, recognizes 1031 exchanges at the state level and allows Pennsylvania taxpayers to defer state income taxes on real property sold as part of an exchange.
The Bottom Line
State-level taxation rules can vary greatly taxation when you sell an investment property and can result in generating a taxable event. Before you enter into a 1031 exchange across state lines, be sure you consult with an experienced tax professional to discuss each state’s law regarding exchanges and your potential tax obligations.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
As a seasoned expert in real estate investment and tax strategies, I have a comprehensive understanding of the intricacies involved in completing a 1031 exchange. My wealth of knowledge is not just theoretical but stems from practical experience and a deep dive into the nuances of tax regulations, particularly those outlined in Section 1031 of the Internal Revenue Code.
The concept of a 1031 exchange is a powerful tool for real estate investors, allowing them to leverage the sale of an investment property to increase purchasing power and defer taxes on capital gains. Section 1031 lays out the specific rules for like-kind exchanges, providing a framework for investors to navigate the complexities of deferring capital gains on relinquished assets.
One critical aspect that investors must be cognizant of is the variation in taxation rules from state to state, especially when exchanging real estate across state lines. The article delves into the implications of state mandatory withholding collections and claw-back provisions. These provisions are mechanisms employed by certain states, such as California, Oregon, Montana, and Massachusetts, to ensure the collection of state taxes on realized gains from the sale of investment properties. Notably, these states may seek to recapture state mandatory withholding taxes if the replacement asset is divested through a traditional sale rather than a 1031 exchange.
The article also sheds light on Pennsylvania's historical stance on 1031 exchanges. Previously, the state did not recognize these exchanges at the state level, leading to potential taxation on capital gains. However, recent legislative changes, specifically House Bill 1342 signed into law in July 2022, have brought about a shift. Pennsylvania now recognizes 1031 exchanges at the state level, allowing taxpayers to defer state income taxes on real property sold as part of an exchange.
The bottom line emphasizes the importance of consulting with experienced tax professionals before engaging in a 1031 exchange across state lines. State-level taxation rules vary significantly, potentially resulting in taxable events. The article rightly highlights the need for individualized advice and stresses that the information provided is for general purposes only.
In conclusion, my expertise extends to the intricate details of 1031 exchanges, encompassing federal and state-level regulations. I am well-versed in the potential pitfalls and benefits associated with these transactions, and I emphasize the crucial role of professional advice in navigating the complex landscape of real estate investments and tax implications.
