Many of our clients who own investment property often ask if they can use a 1031 exchange between states. For example, could they relinquish property in California and replace it with property in Texas? Fortunately, they can, and the practice is quite common.
Since the Internal Revenue Code 26 U.S. Code § 1031, which governs like-kind exchanges, is a federal tax code, by default, all states generally recognize it. And while most states impose their own capital gains tax, most of those states mirror the federal regulations and allow for the deferral of state capital gains.
There are exceptions, however, and it is important to understand different state rules.
Four states - California, Massachusetts, Montana, and Oregon - all have claw-back provisions relating to exchanges. This means that you may potentially be subject to state capital gains tax in two states upon the taxable sale of your replacement property.
For example, if you sold an investment property in Massachusetts and purchased a replacement property in Vermont, you may be responsible for a Vermont capital gains tax of 8.75% and Massachusetts’ (claw-back) capital gains tax of 5.0% when you sell the Vermont property. On the other hand, nine states- Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming - have no state capital gains tax and could provide investors relief from dual state taxation.
That is one reason why, when you are considering a state-to-state exchange, it is critical to work closely with a tax advisor who understands specific state regulations.
Another consideration for owners selling an investment property in a state where they are non-residents is the potential for that state to withhold a percentage of the sale proceeds. Seventeen states have withholding requirements that can range as high as 5% of the sales price or more.
However, some of those states have certain state withholding exemptions for non-residents using a 1031 exchange.1 Taxpayers are generally required to file specific state forms for exemptions, and timelines for filing vary from state to state. As noted above, always consult with a tax professional to ensure you know all state-specific requirements.
Pennsylvania: The Outlier
We mentioned that in general, states recognize Section 1031 of the Internal Revenue Code. Pennsylvania, however, is an outlier and does not acknowledge the 1031 exchange. The state cannot impose its will on taxpayers as far as the federal tax code applies, so investors in the state can still conduct an exchange and defer federal capital gains tax. But Pennsylvania does not afford exchangers that same benefit at the state level, so taxpayers are required to pay a 3.07% income tax on all 1031 exchange transactions.2
The Interstate Advantage
You might find it interesting that the Delaware Statutory Trust (DST), which meets 1031 exchange like-kind requirements, is a driver of interstate exchange activity.
There are a few reasons why:
First, many investors are tired of self-managing their investment property and prefer the passive investment approach of investing in a professionally managed DST that may own property in any state. Second, some DST’s own properties in several different states, providing investors with a degree of diversification they could not otherwise achieve by simply replacing one property with another in their 1031 exchange. Third, they may be able to take advantage of swapping into states that may be more tax advantaged, as mentioned above.
So, know that you can exchange property in one state for property in another state with your transaction. Section 1031 of the tax code allows that. But also know there are nuances at the state level that require expert counsel to help you determine the best approach for your exchange.
As always, if we can help answer any of your questions, do not hesitate to contact us. You can also schedule a free consultation with one of our team members here.