How Are State Taxes Calculate on a 1031 Exchange?

As a qualified intermediary and licensed real estate professional, I’ve personally seen the surge in taxpayers leveraging the power of a #1031 exchange. It is a great way to defer capital gains taxes and more quickly build a portfolio of business or investment properties.

Yet one area where I have seen more than one taxpayer caught out involves the impact of state income tax liability on the transactions, particularly when it comes to interstate exchanges. And since broadening one’s geographic scope is a key driver in many 1031 exchanges, the ramifications of interstate transactions should not be overlooked.

While federal law makes no distinction for exchanges conducted across state lines, some state law does. Sometimes the difference is significant. The good news is that many states use federal taxable income as the basis for calculating state taxes, while others have adopted the IRC to compute state income tax. In those states, the full deferral privileges of section 1031 applies regardless of where relinquished and replacement property is located.

However, a number of states do neither, and instead have their own rules governing interstate exchanges. These states include states like Pennsylvania and California, among others. These states use one of three methods to deal with exchange proceeds, (1) disallowing the deferral, (2) requiring the replacement property to be within the state or (3) clawback provisions.

In each case, gain may be taxed immediately or at a later date. This recent articleoutlines a further explanation of the nuances of these state-specific rules, along with helpful examples. It is key for any taxpayer considering an interstate exchange to fully discuss their circumstances with a qualified tax professional in their home state to understand the tax implications.

To find out how we can help you find and close on your next 1031 exchange property or to learn more about the exchange process and our qualified intermediary services, please visit our website.