A frequently asked question connected to the 1031 exchange is, “Can you execute a 1031 exchange between states?” On the federal level, the answer is a definitive “yes.” Internal Revenue Code 26 U.S. Code § 1031 – “Exchange of Real Property Held for Productive Use or Investment” – falls under federal tax legislation. As such, the process is uniformly recognized across all 50 states and DC.
Through a state-to-state 1031 exchange, you could sell (relinquish) a property in one state, acquire (replace) a property in another, and reap the potential tax deferral benefits from a 1031 exchange. But when you execute a 1031 exchange across states, it’s a good idea to understand like-kind exchange Tax regulations at the state level.
Some of these include the following:
Some states have a “clawback” provision related to the like-kind exchange. Any property value gains accrued and realized through a taxable sale could be subject to state taxes.
Let’s take this hypothetical example. You decide to sell a California duplex and exchange the proceeds for a replacement duplex in Virginia. If executed properly, the exchange should help you defer capital gains and depreciation recapture taxes on that California property.
But you run into the California clawback provision when you dispose of that Virginia duplex through a taxable sale. This means that you could owe capital gains and depreciation recapture taxes, not just in Virginia and on the federal level, but in California.
Nor is California the sole state with claw-back provisions. Massachusetts, Montana, and Oregon also have claw-back provisions for executing a 1031 exchange across states.
California and Oregon also have mandatory tax withholding requirements when non-resident individuals or businesses sell real estate in those states. The following states have this regulation, too:
This means that even if you don’t live in the states mentioned above, you might have to pay a mandatory tax withholding requirement on the sale of real property. In most cases, the tax is a percentage of the sales price. However, an exemption in some states could be available if you’re pursuing a 1031 exchange.
Moving on, these states have no state income tax filing requirements:
You don't have to report real property transactions because you don’t file income tax forms in these states.
The takeaway from the above is that the 1031 exchange can be an effective tax-deferral strategy on the federal level. But when considering a 1031 exchange out of state, it’s essential to understand that regulations can vary by state. Be sure to talk to your tax advisor before entering into a like-kind exchange agreement.