Clients often ask about the complications that may arise from making 1031 exchanges across state lines. Their questions are hard to answer, because procedures for property sales and 1031 exchanges vary from state to state. Researching and adhering to state requirements for property sales is important in a 1031 exchange transaction, but the real concerns for investors are individual state tax laws and how taxes are collected. In particular, if an investor sells a property, the income tax rate in the state in which the sale takes place will be applied to the capital gain, and that rate differs drastically among states.
There Are Low-Tax States and High-Tax States
Internal Revenue Code Section 1031, which lends its name to the 1031 exchange, is applicable in all 50 states and the District of Columbia. Exchanges can be made freely across state lines. IRC 1031 applies to state taxes as well in states that have provisions in their laws acknowledging the exchange.
State income taxes on capital gains, if there are any, are paid in the state in which a sale takes place. Therefore, state tax rates are a concern for investors selling properties that have been used in a 1031 exchange. Seven states—Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming—have no income tax, including on investment income. Therefore, no state tax is connected with the sale of a property in those states. If an investor sells or relinquishes an investment property in any other state, however, some tax will be paid or deferred.
For example, the capital gains on the sale of an investment property could incur a tax bill of a flat 5 percent in Utah, or up to 13.3 percent in California. Thirty-three states, including California, have sliding tax scales, but the top bracket is very low in many cases. In Missouri, for example, the 2017 top tax bracket starts at $9,072.
The five highest 2017 state income tax rates are found in:
- California: 13.3 percent on income over $1,000,000
- Oregon: 9.9 percent on income over $125,000
- Minnesota: 9.85 percent on income over $156,900
- Iowa: 8.98 percent on income over $70,785
- New Jersey: 8.97 percent on income over $500,000
At the other end of the spectrum, eight states, again including California, had minimum 2017 tax rates between zero and 1 percent. The financial impact of state taxes can be high for some investors, so an accountant should examine the state tax consequences before a final decision is made on a 1031 exchange.
States Are in a 1031 Exchange Conundrum
In all states with income taxes, capital gains from the sale of a property are taxable unless they are deferred through a 1031 Exchange.
But in some states, a 1031 exchange has tax consequences that follow it until the property is sold. To understand why this happens, let’s consider a property (Property A) that is owned in a state with income tax (State A). Property A is relinquished in a 1031 exchange. There is a capital gain from the sale of Property A, and it is subject to income tax in State A, but that tax is deferred, and Property A is replaced by a property in another state. When the replacement property is eventually sold, the income tax on the capital gain is paid in the state where the sale took place. State A never receives the tax revenue from the relinquishment of Property A.
Most states accept this loss of potential tax revenue, but not all. California pioneered a procedure known as “clawback,” which tracks the chain of exchanges following a 1031 exchange that relinquishes a property in California with the goal of eventually recapturing the tax revenue from the exchange that originated there. To track this, the state requires that an annual statement be filed on the progress of that exchange. When the property is sold in another state, the tax comes due on the capital gain from the relinquishment that took place in California. As a result, the investor has to pay capital gains taxes in the state where the sale took place and in California on the earlier exchange. Thus, the investor’s tax bill increases significantly. Massachusetts, Montana, and Oregon have followed California’s example, instituting similar mechanisms.
The outlier in all of this is Pennsylvania, in that it simply does not acknowledge the 1031 exchange. Capital gains from property sales in Pennsylvania are subject to a 3.07 percent flat tax, whether those sales are part of a 1031 exchange or not.
There is a wide variation in the ways states handle 1031 exchanges, and high state income taxes can have serious financial consequences for an investor. This is just one more reason why expert advice is critical to the success of any 1031 exchange.
To find out more about the 1031 exchange, read our blog articles on the subject.
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