There is no doubt that section 1031 is a useful tool for investors. We’ve helped hundreds of investors defer substantial capital gain taxes through a 1031 exchange and grow wealth by reinvesting tax-deferred money into a more profitable investment property.
However, there are plenty of rules and regulations associated with this section of the Internal Revenue Code (IRC) to think about. Some of these rules include state taxation. While section 1031 is part of the IRC, which applies to federal taxation, investors also must comply with the state tax laws that apply to their particular exchange.
There are two important aspects of state tax law that often impact investors: state withholdings and clawback provisions. Each state has its own set of tax laws, but this article will hopefully provide you with some familiarity with the basic concepts involved.
State Tax Withholding for Like-Kind Exchanges
While section 1031 allows you and other investors to defer your capital gain taxes at the federal level, you may still be faced with state capital gain taxes triggered by the sale of your property. In fact, most states collect income taxes and impose a withholding requirement on the sale of real estate.
Fortunately, most states that have a withholding requirement also recognize section 1031 transactions and allow for you to file an exemption. When you file an exemption, you are essentially notifying the state that you are conducting a 1031 exchange and that your capital gain taxes will be deferred. You need to be sure you comply with all state tax laws, otherwise you may end up paying taxes you could have deferred.
Here’s an example of how a state withholding requirement could impact your exchange:
Colorado imposes a withholding requirement of 2% of the sales price of the relinquished property or the net proceeds from the sale, whichever is less. However, if the sales price is equal to or less than $100,000, then the withholding requirement is automatically waived. But, Colorado also allows non-residents to file for an exemption when they are doing a 1031 exchange, so as long as you provide this exemption form on time, you will avoid this requirement.
California: An Example of a State Clawback Provision
Certain states have implemented laws that are designed to maximize the state’s income even while recognizing section 1031. California provides the best example of this. The state passed a “clawback” provision that basically allows it to recapture any capital gain realized in California property. Here’s how it works:
Suppose you own a piece of real estate in California for several years, and your real estate appreciates in value during the time you hold the title. If you then decide to sell that California property and exchange into a property located in a different state, California will recapture—or “claw back”—whatever capital gain was carried over from the original California real estate when you eventually sell the replacement property in the other state. This creates a double taxation event whereby you would be liable for the applicable federal and state taxes in the state in which the real estate was held and also in California.
This provision represents an aggressive attempt by California to generate income based on all capital gain on real estate owned within its borders. As of right now, California has the most aggressive provision of this kind, but other states could follow California’s lead in the near future as they try to balance their budgets.
Providing a summary of each state’s tax issues is beyond the scope of this article, as every investor’s situation will be different, but this at least gives you some sense of what’s involved at the state level when a 1031 exchange is done. Because of the complexity involved with like-kind transactions, it’s often helpful to partner with an investment management firm that specializes in them. At CWS Capital Partners, we have decades of experience helping investors through their 1031 exchanges in several states. Be sure to read our white paper to learn more about 1031 exchanges.
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The information provided here is for your general informational purposes only. It should not be considered a recommendation or personalized advisory advice. CWS has made this third party information available from authors it believes are knowledgeable and reliable resources. However, its accuracy or completeness cannot be guaranteed and sentiment may change due to legal or economic conditions.
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