State-to-State 1031 Exchange Rules on Capital Gains Taxes Investors Should Know
Many real estate investors are unsure if they can use a 1031 exchange when selling property in one state and purchasing another in a different state. Fortunately, for all the investors out there, moving markets is not an issue when it comes to 1031 exchanges. You can sell an investment property in one state and use those funds to purchase property in another state within an exchange. This transaction is commonly called a state-to-state 1031 exchange.
How does a state-to-state 1031 exchange work?
In regards to state-to-state 1031 exchanges, most states with income taxes follow the federal tax code and allow taxpayers to exchange property in that state, purchase replacement property in a non-income tax state—and defer the state income tax. However, there are a few exceptions and rules to be mindful of.
What rules do I need to be aware of?
“Claw-back” provisions are an example of an exception to the scenario described above. In states with claw-back provisions, if the replacement property is later sold in a taxable sale—the original state it was exchanged out of, as well as the state it was sold in, will collect taxes on the sale.
The following states have claw-back provisions in place:
Taxpayers need to be cognizant of the claw-back provisions. Investors want to avoid double taxation when they exchange property in one of these states and purchase in an income tax state. A state-to-state 1031 exchange can work for you or it can work against you. The key is to know how the states you’re dealing with treat these transactions.
There are also states that have withholding requirements if the seller of a piece of property in these states is a non-resident of any of the following states: California, Colorado, Hawaii, Georgia, Maryland, New Jersey, Mississippi, New York, North Carolina, Oregon, West Virginia, Maine, South Carolina, Rhode Island, Alabama, and Vermont. Some of these states may have withholding exemptions for taxpayers selling their property using a 1031 exchange. Additionally, Alabama, California, New Jersey, and South Carolina require the QI to remit the withholding amount to the state if the exchange fails or there is taxable boot remaining.
For the first time starting in the 2023 tax year, Pennsylvania will allow taxpayers to defer the state taxes through a 1031 exchange. Prior to this, Pennsylvania did not recognize 1031 exchanges on the state level.
If real estate investors are residents of or are considering exchanging out of or into one of the states mentioned above, it is important to understand how state-to-state 1031 exchanges work and to be aware of claw-back provisions and withholding requirements. This is not only for the current exchange but for any future exchanges as well. Please consult with your tax advisor on the requirements for a particular state.
Related information on 1031 exchanges:
Contact us today for more information on how Midland 1031 can help you understand the basic rules and set up your 1031 Exchange properly.
For real estate investments within IRAs or other retirement accounts, contact Midland Trust at 239-333-1032 or visit www.midlandtrust.com.