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.
