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.
1031 Exchange Blog
Over the past 17 years, we have had the pleasure of guiding thousands of Exchangors through the 1031 Exchange process. Our Blog draws from that experience and includes content ranging from the basics of an Exchange for first time Exchangors to detailed commentary on complex exchanges for the expert investor. If you do not find the topic or specific question you are looking for, reach out to us via email at info@atlas1031.com or call our office to speak with our team at 1 800 227 1031.
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.
California 1031 Exchange Sales Tax Rules
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.
Download the “1031 Ten Point Checklist” for free by clicking here.