If you want to exchange for a property in another state, it’s important to understand how different states treat like-kind exchanges.
Owners of business or investment properties, especially those starting out with their first rental properties, tend to buy close to home. This allows them to actively manage the property, whether that involves dealing with tenants or operating a small business. And when it’s time to upgrade, they can pursue a Section 1031 like-kind exchange into a new property.
But what happens if you move to another state and want a property closer to your new residence, or find an opportunity (such as a DST or triple-net lease) across the country? There are many reasons for wanting to pursue an out-of-state 1031 exchange, but because different states have different tax laws, it can be complicated.
A 1031 exchange between states is called a state-to-state exchange, and while the good news is that you don’t have to stay within the same state to pursue a like-kind exchange, there are some specific rules to understand that may affect your strategy.
How Section 1031 applies to state-to-state exchanges
There are limits to the types of properties that are considered “like kind” under Section 1031. For example, you cannot perform a 1031 exchange between property in the United States and property outside the United States. Per the Internal Revenue Code, “Real property located in the United States and real property located outside the United States are not property of a like kind.”
For property located within the United States, the law applies to all eligible business or investment property, regardless of location. Section 1031 is part of federal law, so it applies to federal taxes, which are the same no matter what state you’re in. You can perform a 1031 exchange between business or investment properties located anywhere in the United States, so long as they meet all other 1031 requirements.
However, property sales don’t just involve federal taxes. There are also state and local taxes to consider, and some states have had laws that limited which taxes could be deferred as part of an exchange. For example, Pennsylvania’s tax code did not match IRC Section 1031 until state law was changed in 2022. Before then, you would have had to pay state income taxes on your relinquished property sale at the time of sale, reducing the amount you’d have to reinvest.
California state-to-state 1031 exchange rules
California is one of a handful of states that includes a “claw-back provision” on 1031 exchanges involving a relinquished California property and a replacement property in another state.
The claw-back provision says that any gain from the sale of property located in California is attributed to California at the time the gain is realized. What this means is that while you can still defer California state taxes in a 1031 exchange, you will owe those taxes when you sell your replacement property in a taxable sale.
For exchanges where the property being sold is located in California and the replacement property is located outside California, the exchanger must report to the State of California once per year confirming that they still own the non-California property.
If the acquired property is sold outright, or if the exchanger fails to file an annual return, the exchanger will owe capital gains tax to the State of California for the portion of the gain that was earned on the asset located in California. However, if the non-California property is sold through an exchange, the exchanger will need to continue reporting ownership of the newly-acquired property to California until they eventually break the 1031 chain through a taxable sale.
The ability of a state to claw back capital gains taxes could potentially cause double taxation depending on the tax laws of the state you’re exchanging into. Other states with claw-back provisions include:
- Oregon
- Montana
- Massachusetts
If you’re exchanging from one of these states, it’s critical to keep detailed records of what taxes are being deferred, because even if you don’t complete a taxable sale until decades down the line, you’ll still owe those taxes when they are due. Massachusetts and Montana do not have an annual filing requirement, but California and Oregon do. If you defer taxes from either of those states, you must file an annual form with the state’s Franchise Tax Board.
This is potentially another reason to perform subsequent exchanges and hold property until your death, when your heirs can benefit from a step up in basis, as this could eliminate worries about a clawback. However, that strategy would require the step up in basis to be a part of the local and state tax codes at the time of your passing, which isn’t guaranteed.
New York state-to-state 1031 exchange rules
New York is one of many states with tax withholding regulations that affect sales of real estate. If you sell a property in New York and are not a resident of the state, you may be subject to mandatory tax withholding, the amount of which will be based on the sale price of the property.
Other states with non-resident tax withholding provisions are:
- Alabama
- California
- Colorado
- Georgia
- Hawaii
- Maine
- Maryland
- Mississippi
- New Jersey
- North Carolina
- Oregon
- Pennsylvania
- Rhode Island
- South Carolina
- Vermont
- West Virginia
The good news is that there is an exemption for properties sold as part of a like-kind exchange. By filling out the proper paperwork, you can pursue your exchange without having money withheld while you’re trying to complete your exchange.
Can I reduce my tax obligation by exchanging from a high-tax state to a low-tax state, then selling in the low-tax state?
Some states have no income tax filing requirement. These states are:
- Alaska
- Florida
- Nevada
- New Hampshire
- South Dakota
- Tennessee
- Texas
- Washington
- Wyoming
Many exchangers hope to sell a property in a high-tax state and purchase a replacement property in a low-tax state. When they eventually sell, the tax burden could potentially be lower because the state taxes will be based on the tax rates of the new state. However, as mentioned, this can become complicated if the state where the relinquished property is held has a claw-back provision.
That’s why it’s important to understand the rules for the state in which you’re selling and the state in which you’re buying, because if your reason for pursuing a property is based on a faulty calculation of a hypothetical tax burden, you could be making a big mistake. Be sure to consult knowledgeable tax and legal experts before going ahead with a state-to-state exchange.
Can I perform a 1031 exchange between a U.S. property and property in a U.S. territory?
Many residents of U.S. territories are U.S. citizens, and may want to take advantage of opportunities on the mainland. But U.S. territories can run afoul of the Section 1031 provision that property “located outside the United States” won’t qualify. How does the IRS treat these territories, which are home to Americans but lie outside the U.S.?
Confusingly, the rule is applied differently to different territories. The IRS has clarified the 1031 eligibility of three territories: Guam, the U.S. Virgin Islands, and the Northern Mariana Islands. Other territories, such as American Samoa and Puerto Rico, are not eligible.
If you’re considering a move to Puerto Rico, it’s worth noting that nearly all of the island lies within a Qualified Opportunity Zone, offering other chances for tax deferral. There’s also long been talk of statehood for Puerto Rico, which could lead to changes in how Section 1031 is applied on the island. Rules can change, which is why it’s beneficial to work with service providers utilizing the most current information.
Making sure your planned exchange qualifies
While state-to-state and even state-to-territory exchanges are possible, they can have added complications, and if you aren’t careful, you could end up with an invalid exchange or violate state tax laws. You need service providers who understand the complexities of 1031 and care about complying with the law.
At JTC, our team is experienced in all manner of 1031 exchanges, including multiple property exchanges, reverse exchanges, and those involving Delaware Statutory Trusts. We’ve pioneered best practices for keeping investor funds secure, providing full transparency through our 24/7 online portal, and taking extra steps to ensure regulatory compliance. When you’re ready to pursue a 1031 exchange, work with a Qualified Intermediary that will give your exchange the care it deserves.
To learn more about JTC’s Qualified Intermediary services, click here.
