On the whole, Internal Revenue Code (IRC) section 1031 offers investors a great opportunity to defer income tax on recognized gain from an exchange of qualified like-kind property. Doing a 1031 exchange has many benefits—it can allow you to diversify your portfolio, take advantage of new real estate markets, and invest in a different type of investment property.
Still, some 1031 exchanges can be complex. Interstate 1031 exchanges can be a bit tricky, yet they allow you to take advantage of favorable market conditions in different regions. In some situations, the perks come with additional hurdles. The hurdles presented by interstate exchanges are no reason to run for the hills, but they often do require a bit more planning.
Federal vs. State Income Tax for 1031 Exchanges
The first point we should understand is that section 1031 is a federal code and specifically refers to taxable income at the federal level. Section 1031 isn’t specific to state law, and the provisions of section 1031 say nothing about the particular regulations and tax computation of any particular state.
When you conduct a like-kind exchange that fully complies with all of the rules of section 1031, you have achieved tax deferral at the federal level, but there can be different demands placed on you depending on the state (or states) in which the exchange occurred.
Some states have no state income tax, for instance, so an interstate transaction involving two states that both have no state income tax would produce very little additional complexity. Most states recognize section 1031 and allow the gain to be deferred at the state level. Other states only allow the gain to be deferred at the state level if investors acquire a replacement property located within that same state. In short, the full complexity of your exchange will depend on which states will be involved in your interstate transaction.
Let’s use a concrete example to get a better sense of what an interstate transaction can entail. Suppose you’re a resident of the state of Washington, but you own investment real estate located in the state of Rhode Island, and you want to use this real estate as your relinquished property.
When you sell your property in Rhode Island, you will be required to pay a 6% sales tax on the transaction (9% for non-resident corporations). This is true regardless of where your prospective replacement property is located. However, because Rhode Island recognizes 1031 exchanges, you can file for an exemption by completing and submitting an exemption form (RI Form 71.3) to the Rhode Island Department of Taxation.
Understanding State Laws
Whenever you conduct an intrastate 1031 exchange—that is, an exchange in which the relinquished property and replacement property are both located within the same state—it’s still important to ensure that all state laws are properly accounted for.
When you conduct an interstate exchange, you need to understand the laws of all states involved in your transaction. The local regulations governing 1031 exchanges can be fairly convoluted at times, so it’s often recommended to rely on the real estate investment management firm you choose to partner with for your exchange.
If you perform this task by yourself, a good way to start is to review the state website for whichever state you plan to conduct business. For instance, in the state of Washington, you would review the Department of Revenue’s website. After you investigate the relevant state laws, you’ll have a better sense of how difficult the transaction will be.
There is a chance, for instance, that you may discover you will incur a state tax as a consequence of your interstate exchange and then subsequently avoid the transaction altogether. In-depth research will help you determine whether your particular interstate 1031 exchange is worth the additional effort.
State to Avoid
The state of Pennsylvania currently does not recognize section 1031 exchanges and both residents and non-residents are required to pay state income tax (of 3.07%) on any sale made within state lines. This is true even for those who successfully complete a 1031 exchange when they acquire a replacement property within the state of Pennsylvania. In short, Pennsylvania imposes the harshest burdens on investors and so you should try to avoid making 1031 exchanges in this state.
1031 Exchange and Investment Management Expertise
There is no easy way around it: If you’re going to conduct an interstate exchange, you will incur additional homework, regardless of your state residency status. The best scenario is that the state you’re selling your relinquished property in does not impose a state income tax. In this case, you won’t incur an extra tax burden and won’t have to file an extra state income tax return.
Make sure to research the state laws that will apply in your particular case and determine whether the transaction is desirable. One way to do that is to rely on the expertise of your investment management company. Our experts at CWS Capital Partners can assist you as you navigate through this process.
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