How Does a 1031 Exchange Affect State Income Taxes?

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 more than one taxpayer has been caught out involves the impact of state income tax liability on the transactions, particularly when it comes to interstate exchanges. Since broadening geographic scope of investments 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. It is critical 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.

If a 1031 exchange is in your future, visit our website to learn more about these powerful tax deferral tools and our qualified intermediary and replacement property locator services.