The 26 U.S. Internal Revenue Code § 1031 is a handy tool if you own real estate used for trade or investment purposes and want to sell it without immediately triggering taxes on the capital gain on that sale. However, as we’ve mentioned in a previous blog, the like-kind exchange functions on a federal level. You can do a state-to-state 1031 exchange, which involves swapping your relinquished property in one state for a replacement property in another.
But when you go this route, it’s important to know that some states have a clawback provision. It’s important to understand the clawback rules, as it could lead to double taxation down the road.
States That Reveal Their "Claws"
The clawback provision involves state-to-state 1031 exchanges. Specifically, what happens when you swap your relinquished property in California, Massachusetts, Montana, and Oregon for a replacement property in another state.
Your capital gains taxes on the federal and state level will continue to be deferred. At least, until you sell that replacement property in a taxable sale. When that happens, your capital gains will be taxed at the federal level. They’ll also be taxed at the state level if there is state income tax. And, if your original relinquished property was in California, Massachusetts, Montana, or Oregon, you’ll owe those states tax on the capital gains as well.
Let’s clarify this with a hypothetical situation. You own a duplex in Massachusetts and decide you’re tired of dealing with cold weather, snow, and shovels. So, you find a Qualified Intermediary, exchange out of your duplex (the relinquished property), identify a nifty apartment complex in Mississippi as the replacement property, and complete the exchange well within the IRS-mandated deadline.
You happily operate that Mississippi apartment complex for several years. Then you notice a high investor demand for small apartment complexes in the Magnolia State. It’s a good time to get out of your current situation, you think. You put that complex on the market, it sells quickly, and you receive a nice profit for your efforts.
You already know you’ll owe the state of Mississippi a 7% tax on the profits from that sale. You could also be on the hook for a federal capital gains tax rate of up to 20% (depending on hold time and your income tax bracket). Also in line? The state of Massachusetts, with its own demand for taxes. How much tax you pay in states with clawback provisions can vary, based on tax rate, schedules, and other criteria. But you will owe if your relinquished property is in a state with a clawback provision.
Reducing The Potential for Claw-Back Taxes
Though clawback provisions exist, there are a couple of potential ways to avoid triggering them:
Continue deferring capital gains taxes through ongoing 1031 exchanges. This can help reduce capital gains taxes at the federal and state tax level, especially among states with clawback provisions. When you die, the replacement property you own is “stepped up” to fair market value, which eliminates capital gains taxes for your heirs and beneficiaries.
Exchange into in-state replacement properties. For example, exchange your California real estate investment property for another in the Golden State, rather than considering an out-of-state like-kind property. You’ll still owe taxes when the replacement property is disposed of in a taxable sale, but you could avoid double-taxation.
If you decide to target California, Massachusetts, Montana, or Oregon for real estate investment, be sure you have all the information should you decide to exchange into an out-of-state property. Talking to a tax advisor can help you develop the best possible scenario for your specific portfolio.
