We are pleased to share this guest blog provided to our readers by Lisa Villarreal, Business Development Manager at First American Exchange Company. First American Exchange Company is a subsidiary of First American Financial Corporation (NYSE: FAF) with revenues of $7.6 billion in 2022.
1031 Exchanges and Other Tax Aspects
Investors often sell property in one state and purchase real estate in another state – whether to achieve greater portfolio diversification, increase the power of their dollar, or move investments to their state of residence, there can be benefits to moving an investment from one state to another. A taxpayer may take this approach when completing a tax deferred 1031 exchange. This is permissible because real estate located in one U.S. state is considered “like-kind” to real estate located in any other state for exchange purposes.
In most cases, exchanging out of state allows a taxpayer to defer both state and federal income taxes (assuming the state has income taxes). However, note that taxpayers doing an exchange should always consult with their tax advisor regarding certain nuances that may apply from state to state to recognition of tax-deferred exchanges.
Certain states have special “claw back” laws that allow the state to track a taxpayer’s subsequent purchases and sales of property using proceeds from a property sold in that state. This way, when capital gains become due, the state can collect tax on the gains allocable to that state, even years later. This can at times result in double taxation as to some portions of a taxpayer’s capital gains. Currently, state with these claw back laws include California, Massachusetts, Montana, and Oregon.
For example, for purposes of determining California state income tax, any gain or loss from the sale or exchange of property located in California is attributed to California at the time the gain or loss is realized. Even if a taxpayer does not live in California, but exchanges property located within California for property located outside California, the realized gain or loss is still attributed to California.
Example: As a resident of Texas, a taxpayer exchanged a condominium located in California for like-kind property located in Texas. They realized a gain of $15,000 on the exchange that was properly deferred under IRC Section 1031. They then sold the Texas property in a nondeferred transaction and recognized a gain of $20,000. The $15,000 deferred gain (the lesser of the deferred gain or the gain recognized at the time they disposed of the Texas property) has a source in California and is taxable by California.
Payment of any tax is deferred until the replacement property is sold and the gain is recognized; but taxpayers need to track and report any deferred California gains and losses to the California Franchise Tax Board (FTB) using Form FTB 3840 for the taxable year of the exchange, and for each subsequent taxable year in which the gain or loss from that exchange has not been recognized. This is required even if the taxpayer does not otherwise have a California filing requirement.
Claw back rules in Massachusetts, Montana, and Oregon work similarly to the California rule discussed above. Massachusetts and Montana, in contrast to California, however, do not have an annual filing requirement. In Oregon, a taxpayer must file Form 24 each year after the disposition of Oregon relinquished property until gain is ultimately recognized.
In addition to claw back rules, many states have withholding requirements when an out of state investor sells property located there. Typically, these rules require the closing agent to withhold a percentage of the proceeds and remit them to the taxing authority as a type of security or deposit on the tax that will be paid once a tax return is filed. Some states have exceptions to withholding if an exchange is done by the seller, the requirements for which vary depending on the state.
As discussed above, so long as taxpayers understand the particular state issues that may come up, it is possible to exchange from one state to another successfully. However, a taxpayer cannot exchange United States property for property outside of the United States. Under Section 1031, domestic and foreign properties are not considered like-kind. A taxpayer may, however, exchange foreign property for other foreign property.
Whether you’re exchanging from one state to another domestically, or you have foreign property you are considering including in a 1031 exchange, be sure to consult with your tax advisor to understand what state or other specific requirements you may need to keep in mind in order to have a successful exchange transaction.
We encourage you to contact the professionals at First Guardian Group as well as your personal tax and legal specialists to learn more about out-of-state real estate investments.