1031 Exchanges & State Tax Law Considerations

A successful like-kind exchange of real estate under IRC §1031 defers capital gains tax and depreciation recapture on a federal level. Nevertheless, the ability of a taxpayer to defer taxation on the state level depends on the state in which the real estate is located, among other considerations.

Certain states, like Florida and Texas, have no state income tax. Consequently, the exchange transaction does not need to be reported on the state return as it would on the federal reporting form, IRS Form 8824. Most states follow the federal statute and thus defer the state tax on the gain. An outlier is the Commonwealth of Pennsylvania, which does not recognize 1031 exchanges. Tax must be paid on a state level in Pennsylvania after completion of a 1031 exchange. However, that doesn't necessarily mean that a 1031 exchange isn't the right choice for a Pennsylvania taxpayer. Even though the taxpayer would still have to pay state taxes on the capital gain in Pennsylvania, federal taxes would be deferred.

Further, certain taxpayers may have to satisfy withholding or exemption reporting requirements in the following states:

• Alabama
• California
• Colorado
• Georgia
• Hawaii
• Maine
• Maryland
• Mississippi
• New Jersey
• New York
• North Carolina
• Oregon
• Rhode Island
• South Carolina
• Vermont
• West Virginia

California, specifically, has a unique state tax statutory scheme for exchanges. Effective January 1, 2020, California requires tax withholding for specific real estate sales in which the gain or loss from the exchange was not recognized for federal income tax purposes (such as in the case of a failed exchange) because of IRC §1031 in order to address the avoidance of income taxes otherwise due and payable to the state when the gain or loss from the property is ultimately recognized. No withholding is required on the initial transfer where the seller certifies on California Franchise Tax Board (FTB) Form 593 that the transfer will qualify as a:

• Simultaneous Refers to the "nature or character" of the property and not to its "grade or quality." That is, real property held for investment or the productive use in a trade or business may generally be exchanged on a tax-deferred basis for other real property. Personal property held for investment or the productive use in a trade or business may generally be exchanged on a tax-deferred basis for other personal property, provided the personal property is of "like kind" or "like class." Professional tax advice should be obtained when planning exchanges. Like-Kind Exchange. However, if the seller/transferor receives proceeds (including excess debt relief) or non-like-kind property from the sale (boot) in excess of $1,500, withholding is required at 3 1/3 percent of that amount, unless an election is made to use the alternative withholding calculation on FTB Form 593;
• Deferred Refers to the "nature or character" of the property and not to its "grade or quality." That is, real property held for investment or the productive use in a trade or business may generally be exchanged on a tax-deferred basis for other real property. Personal property held for investment or the productive use in a trade or business may generally be exchanged on a tax-deferred basis for other personal property, provided the personal property is of "like kind" or "like class." Professional tax advice should be obtained when planning exchanges. Like-Kind Exchange. If the seller/transferor receives any proceeds (including excess debt relief) or non-like-kind property from the sale (boot) in excess of $1,500, withholding is required at 3 1/3 percent of that amount, unless an election is made to use the alternative withholding calculation on Form FTB 593; or
• Failed Exchange. Notwithstanding a certification by seller/transferor on FTB Form 593, if the exchange fails, does not occur, or does not meet the IRC §1031 requirements, the qualified intermediary or exchange accommodator must withhold at 3 1/3 percent of the sales price, unless an election is made to use the alternative withholding calculation on FTB Form 593.

In order to comply with the California Real Estate Withholding Requirements, the seller/transferor is required to promptly provide any and all information, documentation or amounts required to be paid on FTB Form 593-V.

Moreover, Section 1031 claw-back rules apply in the following states:

• California
• Massachusetts
• Montana
• Oregon

When relinquished property is sold and replacement property purchased in another state, the aforementioned states claw-back the gain when the replacement property is eventually sold. Each of the four states has its own state-specific claw-back rules.

Another state tax consideration is whether the real estate is located in a community property state. In a community property state, real estate and other assets owned by married spouses is considered marital property. Married spouses are not considered separate taxpayers for real estate that they own together. This is helpful information for taxpayers to know, for example, in cases where married spouses want to form an LLC for their exchange; that LLC, though having both spouses as members, would still be considered a disregarded entity in the following nine community property states:

• Arizona
• California
• Idaho
• Louisiana
• Nevada
• New Mexico
• Texas
• Washington
• Wisconsin

Lastly, the rules dealing with the structure of 1031 transactions and requirements of persons or entities engaged in the Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary services for taxpayers vary in several states. For example, the 1031 exchange may need to be set up through a qualified escrow holder or qualified trustee, or the Exchange Facilitator may need to maintain a fidelity bond in order to perform the exchange in the state. The following states have enacted legislation concerning the structure of 1031 exchange transactions and those persons or entities facilitating them as Qualified Intermediaries or Exchange Facilitators:

• California
• Colorado
• Idaho
• Maine
• Nevada
• Virginia
• Washington

A taxpayer is well served by finding an exchange company that is well versed in the complexities surrounding 1031 exchanges and the tax law considerations associated with them. As with all matters concerning 1031 exchanges, it is highly advisable to consult with an independent professional regarding the legal and tax consequences associated with any proposed transaction.

To learn more about the considerations for deferral state tax, we offer a free, no obligation consultation with one of our subject matter experts.