Effective January 1, 2014, for California 1031 exchanges initiated for property within the state and replaced with property acquired outside the state, the taxpayer must file the status of the replacement property with the California Franchise Tax Board (FTB) each year until the property gain or loss is recognized using California FTB form 3840. For the FTB form and instructions go to the following link. If the taxpayer elects not to file, the deferred state capital gain is due even if the property was not sold. Assembly Bill 92 and Revenue and Taxation Sections 18032 and 24953 became law on June 27, 2013. This development reflects the California deficit challenges and lawmakers seeking opportunities to clawback state capital gain tax revenues.
Andy Gustafson
LKE Program and Taxpayer Acquiring Equipment from Affliates
In the general course of business the sale of property that results in a gain is subject to capital gains tax. A taxpayer who wishes to avoid payment of capital gains taxes may be able to structure the transaction as an exchange instead of a traditional sale. Under Section 1031 of the Internal Revenue Service Code, transactions that qualify as an exchange are tax-deferred for the purpose of capital gains tax. A Section 1031 Exchange involves the exchange of “like-kind” property held for use in trade, business, or investment.
Qualified Intermediary Negligence Part II
In 1031 exchange Tax Court case Kreisers vs First Dakota Title Limited, the Plaintiffs wished to relinquish a former office building and construct a new one. Plaintiffs had no special knowledge of real estate transactions or Section 1031 Exchanges, though they were aware that structuring their planned transactions as a Section 1031 Exchange would be beneficial from a tax standpoint.
Qualified Intermediary Negligence Part I
A taxpayer who wishes to avoid paying capital gains taxes on the sale of real property may choose to enter into a Section 1031 Exchange transaction in lieu of a traditional sale. A transaction that meets all of the requirements for a Section 1031 Exchange will result in a deferral of federal and state capital gains and depreciation recapture tax that would otherwise be due on the realized gain. To qualify for Section 1031 treatment a transaction must meet several requirements or rules.
2013 Capital Gains Tax and Impact on 1031 Exchange
Internal Revenue Service Section 1031 exchange has garnered renewed interest from CPAs, tax attorneys and individual investors as a result of higher federal capital gain tax rates effective January 1, 2013. A 1031 exchange defers the federal and state capital gain and depreciation recapture taxes when selling real and personal of equal or greater value property productively used in a trade, business or investment and replaced with like kind property within 180 calendar days of the initial closing. Real property such as land, condominium, multi-unit apartment complexes, shopping malls can be exchanged for other real property while aircraft, equipment, livestock, vintage or collectible cars, artwork and precious metals must be exchanged for like-kind personal property.
Clawback and Withholding Requirements in a 1031 Exchange
In a conventional sale of real property, the seller realizes a gain upon the sale of the property – at least that is the objective. That realized gain is then subject to the payment of capital gains tax at the federal, and in some cases the state, level. To avoid the payment of capital gains tax, taxpayers often structure a transaction as an exchange instead of a traditional sale.
Qualified Intermediary Role
Under Section 1031of the Internal Revenue Code, an exchange of property may qualify for a deferral of capital gains tax if a number of requirements are met. One of those requirements is that a Qualified Intermediary, or QI, is used to facilitate the transaction. Also referred to as an exchange accommodator or exchange facilitator, the QI serves as an intermediary throughout the entire exchange process. All funds used during the transaction are held by the QI who then releases them to the appropriate party at the appropriate time.
A taxpayer who has completed a Section 1031 Exchange during the tax year will claim a deferral of capital gains tax due on the transaction when it comes time to file federal taxes for the year. Most taxpayers, however, are also required to file state tax returns. Moreover, individual states implement their own tax laws, meaning that a taxpayer who has participated in a Section 1031 Exchange must also understand the state laws relevant to the transaction to determine if any tax is due. Those same state laws will also dictate what a QI’s obligation is with regard to state tax obligations. Finally, all of this becomes even more complicated if the taxpayer relinquished a property in one state but was a resident of another state and/or the taxpayer relinquished a property in one state and exchanged it for a property in another state. How are all of these issued handled by California, Oregon, Montana and Massachusetts?
Clawback Tax on Realized Gain
There are several steps required in analyzing your potential state tax liability if you are an out of state resident involved in a Section 1031 Exchange. First you need to determine if the state where the property is located typically taxes the gain realized on the sale of real property. California, Oregon, Montana, and Massachusetts all tax realized gain on the sale of real property. Next, you need to consider if your transaction qualifies for an exemption from the payment of state capital gains taxes. In other words, does the state tax code recognize the transaction as a Section 1031 Exchange and, therefore, exempt the transaction from the payment of state capital gains tax? Again, all four states exempt a Section 1031 Exchange from state capital gains taxes. The exemption notwithstanding, the QI involved in your exchange may still be required to withhold funds. In California, for example, a QI is required to withhold 3 1/3 percent of the sale price on equity boot or cash received by an individual and forward the funds to the Franchise Tax Board. In addition to the withholding requirement found in some states, a non-resident taxpayer in all four states is required to file an annual report or return with the state tax authority regardless of whether or not taxes are due and/or whether or not funds were withheld. California Assembly Bill 92 effective January 1, 2014 requires the taxpayer who exchanged property in California in a Section 1031 Exchange for a replacement property outside California to file a return with the Franchise Tax Board for each year the property is held.
The obvious question at this point should be “Why would a QI be required to withhold funds on an Exchange that is exempt from state capital gains tax?” The reason is that although many states treat a federal Section 1031 Exchange transaction the same for the purpose of state capital gains tax, they eventually recapture the tax due through “clawback” provisions. In essence, a “clawback” provision allows the state to collect capital gains tax when a replacement property in a Section 1031 Exchange is eventually sold in a traditional sale. Remember, a Section 1031 Exchange only defers the payment of capital gains tax, it does not exempt the transaction entirely.
If you decide to enter into a Section 1031 Exchange as an out-of-state resident in any state be sure that you have a thorough understanding of the state tax laws relating to the transaction as well as your obligations under the state law.
To learn more about 1031 exchanges, download “Ten Reasons Why a 1031 Exchange Makes Sense” by clicking here.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.