“Is it possible to sell a business property in one state and complete a 1031 exchange by purchasing a replacement property in another state?”
Fortunately, with one exception that we will discuss below, the general answer is “yes.” However there are several potential issues that investors should understand that we will cover in this blog post.
Since the 1031 exchange is part of the Federal IRS tax code, the treatment of tax deferral benefits and reporting is fairly uniform across most states at the Federal level. Also, many, but not all states, closely follow the Federal process for state reporting of 1031 exchanges completed by their residents or involving properties sold in their state by non-residents. Here are several applicable rules in some states that investors should be aware of:
Claw-back Provisions
These regulations come into play when an investor sells a property in a state with a claw-back provision and completes a 1031 tax deferral by purchasing a property in another state. When that newly acquired property is sold in the future and there are funds that were not utilized in a subsequent 1031 exchange, the state where the original property was sold will be entitled to collect state taxes on those funds. Claw-back provisions in combination with taxes owed in the state where the replacement property was sold could potentially lead to double taxation on funds that are not fully deferred in a new 1031 exchange. Currently claw-back provisions for 1031 exchanges exist in California, Oregon, Massachusetts, and Montana. California is the most rigorous state in enforcing claw-back provisions in that they require sellers of business properties to file annual updates in their tax returns so the state tax authorities can monitor the replacement property in future years and be ready to collect taxes on any amounts that are not reinvested in a future 1031 exchange.
Mandatory Tax Withholding for Non-Residents
The states of Alabama, California, Colorado, Georgia, Hawaii, Maine, Maryland, Mississippi, New Jersey, New York, North Carolina, Oregon, Pennsylvania, Rhode Island, South Carolina, Vermont, and West Virginia currently require a mandatory tax withholding when non-residents sell a business property in their state. As an example, California requires that 3.33% of the sales price of a property owned by a non-resident must be withheld at time of sale. Non-state resident investors who complete a 1031 exchange may be granted an exemption, however they must submit a state form within a designated time-period to be eligible for the exemption.
Pennsylvania Does Not Recognize 1031 Tax Deferrals
Yes, that’s right – Pennsylvania has long been the sole hold-out among all our states to not recognize 1031 tax deferral benefits. When a business property is sold in Pennsylvania, a tax is generally owed. There have been numerous efforts over the years to have Pennsylvania conform to 1031 tax deferral provisions, but none have been successful.
What About 1031 Exchanges in Foreign Countries?
Sellers who sell business properties in the US cannot complete 1031 exchanges when purchasing replacement properties in locations outside of the US. As a US resident, you may however invest in a property in a foreign country and use the 1031 exchange when that property is sold to invest in another business property location outside the US.
Keep in mind that most investors must report all their worldwide income when filing US tax returns – so a 1031 exchange may be a useful strategy even when selling properties in countries with no capital gains taxes such New Zealand, Jamaica, or Singapore.
Conclusion
While there is a great deal of flexibility in competing 1031 exchanges between states, readers who are contemplating such transactions are strongly urged to contact a knowledgeable real estate tax advisor for assistance in determining potential tax and filing obligations. For more general information or to receive referrals to real estate tax professional, please contact us by phone toll-free at 866 398-1031 or via email at info@FGG1031.com. You an also schedule a meeting on my calendar here.
1 Depreciation deductions for residential properties can be more favorable than for commercial properties due to differences in allowed depreciation schedules. Investors who are comparing residential commercial investments should consider after tax cash flows.
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