In a 1031 exchange, real property is exchanged for like-kind property to qualify for deferral of federal and state capital gains and recaptured depreciation taxes. In a two property exchange, there is a first leg when the old or relinquished property is sold, followed by the second leg when the replacement property is acquired. In each leg, sales tax is imposed on the Seller of the property and collected at time of the closing or prior to when the property is conveyed to the Buyer. Every state has a sales tax and are often referred to under a different term such as transfer tax.
Transfer Tax
There are many types of sales taxes depending upon the state and property sold. Seven states, including Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming do not have an income tax. Consequently, they along with other states assess taxes on other transactions. Florida imposes a transfer tax on the conveyance of real estate. Texas does not have a transfer tax when retitling real estate. 1031 exchanges are impacted by transfer taxes in reverse exchanges when real property is temporarily titled or parked with an Exchange Accommodator Titleholder or EAT. The EAT’s purpose is to hold either the new or old property, then convey to either the taxpayer or Buyer. North Carolina assesses a tax when the property is conveyed to the EAT and when the EAT conveys it to the final party. Florida recognizes the EATs role and assesses the transfer tax once.
California 1031 Claw Back Sales Tax
Some states such as Oregon, California, Montana, and Massachusetts have “claw back” statutes that tax the realized gain in the sale of real property “in” state when the “out” of state replacement property is sold in a nondeferred transaction.
Effective January 1, 2014, California Assembly Bill 92, Revenue and Taxation Code Sections 18032 and 24953 require residents and non-residents who sell California real property and replace with out of state property to file an income tax return with the Franchise Tax Board for each year the gain or loss has not been recognized or paid. If the taxpayer fails to file, the deferred gain is due, regardless whether the replacement property was sold.
If California property is sold in an exchange by an individual, single member limited liability company or trust, California Revenue and Taxation Code Section 1866(2) requires the Qualified Intermediary to withhold 3 1/3 percent of the sales price (net equity and retired debt) if either (i) the exchange does not take place or (ii) the statutory time periods set forth in IRC Section 1031(a)(3) (the 45-day identification period and 180-day exchange period) expire without the receipt of Replacement Property.
Taxpayer will be credited with any California withholding tax against California’s income tax liability. If these California withholding provisions apply, the Qualified Intermediary (QI) will file California Form 597 within twenty (20) days following the month of the event requiring withholding as provided in the Instructions to Form 597, including sending Copy A of Form 597 to the Franchise Tax Board (with payment of the withholding tax) and sending Copy B and C to Taxpayer. QI shall charge and receive the maximum statutory fee of $45 for such assistance, including withholding and remitting the tax to the Franchise Tax Board.
Example
A resident of Florida sells an apartment building in California resulting in a realized gain of $100,000. The gain is deferred in a 1031 exchange for real property in Florida. The property in Florida is later sold without entering into 1031 exchange, recognizing a $50,000 realized gain. The $100,000 is subject to California claw back tax, in addition to federal capital gain and recaptured depreciation taxes.
The Deferred Sales Trust can be initiated to defer the captial gain as an alternative should the Taxpayer not wish to acquire replacement property.
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