State-to-State 1031 Exchange Rules on Capital Gains Taxes Investors Should Know

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 a 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 allow taxpayers to exchange property in that state, purchase replacement property in a non-income tax state—and defer the state income tax. If the investor later sells the replacement property, the sale of the property will not be subject to the income tax of the state the property was originally sold in as long as the taxpayer is not a resident of that state.

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:

  • California
  • Oregon
  • Montana
  • Massachusetts

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, Delaware and Vermont. Some of these states may have withholding exemptions for taxpayers selling their property using a 1031 exchange.

Finally, Pennsylvania has different rules concerning tax code section 1031 and whether a taxpayer can defer gains in an exchange.  The tax code states that a taxpayer can only defer gains if it is allowed under the method of accounting that the taxpayer uses.  So, when it comes to residents and property held in the state of Pennsylvania, it is very important for taxpayers to consult with their tax professionals prior to entering into a 1031 exchange to make sure that taxes from the sale can actually be deferred.

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 claw-back provisions and withholding requirements.  This is not only for the current exchange, but for any future exchanges as well.

Related information on 1031 exchanges:

Introduction to Real Property 1031 Exchanges

Like-Kind Exchanges Under IRC Code Section 1031


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