Can You Do a 1031 Exchange in a Different State?

In 2019, the California Franchise Tax Board (FTB) imposed a $828,000 state tax on Silverado Lodging for a multi-state 1031 exchange it carried out in 2015. The state found and exploited a tax provision in the transaction that eventually disqualified its tax-deferred status and opened the company to immediate federal capital gains tax liabilities.

So, yes, you can do a 1031 exchange in a different state legally. But it’s one thing to do a 1031 exchange and another thing to do it well enough to avoid future problems with the IRS or state tax boards. This kind of issue is why you must not compromise in your choice of a Qualified Intermediary when doing a multi-state exchange.

As one of the best Qualified Intermediary service providers in Los Angeles, Universal Pacific 1031 Exchange understands the importance of due diligence and cautious compliance steps in the execution of inter-state 1031 exchanges. That’s why we’ve successfully helped hundreds of clients defer capital gains taxes in such scenarios. Contact us now for a free consultation before starting your exchange.

In this article, you’ll learn what a multi-state exchange entails, what to consider when doing a 1031 exchange involving different states, and best practices for such exchanges.

What Is a 1031 Exchange?

A 1031 exchange, named after Section 1031 of the Internal Revenue Code (IRC), allows taxpayers to defer taxes by reinvesting the proceeds from the sale of an investment property into acquiring a new replacement property. Deferring means you owe capital gains tax, which you are only liable to pay the moment you sell for cash.

This process is governed by certain rules, one of which is that both the relinquished and replacement properties must meet the like-kind requirement. This is to say that they must be real estate properties held for investment or business purposes. 

Private residences and vacation homes don’t apply unless they’ve been duly converted to investment assets. Similarly, foreign properties do not qualify for a 1031 exchange; only real estate investment properties held within the 50 states in the US are eligible for a like-kind exchange.

Another important rule is that the replacement like-kind property must have equal or greater value than the relinquished property. If there was a mortgage on the relinquished real property, you must take a new mortgage on the new property that is equal to or greater than the former.

Is a Multi-State 1031 Exchange Allowed?

Yes, a multi-state 1031 exchange is allowed under the IRS Code as long as it meets all the IRS requirements. There is a common misconception among investors that both old and new properties must be in the same state, but that’s not the case. 1031 exchanges are governed by federal laws and not state laws. 

There is no provision in Section 1031 of the Internal Revenue Code (IRC) that the relinquished and replacement properties must be located in the same state. The most important thing is that the properties are similar in nature, not their location.   

How Does a 1031 Exchange Work Across State Lines?

While you can easily exchange properties across state lines without hassles, you must ensure your transactions are compliant with state laws. Some states impose state-level taxes on real estate gains and go the extra mile to enforce it even in a multi-state exchange using “clawback provisions.”

When you sell a property outside the provisions of a 1031 exchange, you must pay the applicable state income tax. But when you exchange it for a new like-kind property in another state, the state where the transaction originated may potentially miss out on its state taxes, which is why the claw-back provisions exist.

Clawback provisions in state tax laws empower them to collect income tax on the deferred gains made when you exchange property in their jurisdiction for a replacement investment property in a different state. So, the state will patiently track the deferred tax status of your like-kind exchanges until you eventually sell for profit.

Even if you sold for profit after conducting a loop of ten 1031 exchanges, the state clawback rule allows it to take tax on the last transaction that happened in their jurisdiction. Clawback is applicable in California, Idaho, Massachusetts, Montana, and Oregon, and is enforceable through annual tax filings capturing the deferred gains.

Some other states, such as Maine, Maryland, New Jersey, and New York, devised a tax withholding strategy aimed at not missing out on the state income tax from any taxable sale. If you’re a non-resident of the state or you’re purchasing a replacement property outside the jurisdiction, you will be required to pay upfront a percentage of the state tax.

The exact clauses behind this law differ from state to state. However, the state typically refunds you when they’ve ascertained that the real estate transaction is fully IRS-compliant. In contrast, the 1031 exchange rules in Texas, Alaska, Florida, Nevada, Washington, and a couple of others are relaxed because of the absence of state income taxes.

Due to the obvious complexities, it is crucial to not just hire any QI but one with adequate knowledge of multi-state transactions in the jurisdiction of both properties. We can’t overemphasize the need for a proper understanding of the various state laws and their implication on a 1031 exchange. 

Moreover, it is important to note that despite all these, the IRS still expects mandatory compliance with the 1031 exchange timeline rules. So, whether you are performing an out-of-state exchange or not, the 45-day identification rule and the 180-day exchange period must strictly be adhered to. 

What to Consider When Doing a 1031 Exchange in Another State

Executing a successful multi-state exchange in itself can be very challenging, so it is necessary to carefully consider the following factors before carrying out a state-to-state exchange:

Be Aware of State Tax Clawback Rules

As discussed in the previous section, certain states have clawback rules that allow them to levy state taxes on the gains realized from the sale of any property in a 1031 exchange. These states can track your deferred capital gains, even if you move your commercial property out of the state.

For instance, if you sell a rental property like a duplex in California and do a 1031 exchange to purchase real estate located in Texas, which has no state income tax, you don’t immediately pay taxes on your gains.

Over the years, when you later sell the Texas property and take the profit, California comes after you for the tax originally deferred. And because this does not exempt you from the federal capital gains tax, it automatically results in double taxation.

It is important to note that even if a taxpayer does not reside in California but performs a real estate transaction with California property for property located outside California, the profit or loss is still attributed to the state. To enforce this clawback rule, California requires you to file Form FTB 3840 every year till you eventually sell the out-of-state property. This form does three things:

• Reports the exchange to California’s tax authority, FTB.
• Tracks your deferred gain over time.
• Ensures that when the investment property is eventually sold, California can take its share of the capital gains tax and depreciation recapture taxes.

In Oregon, taxpayers are expected to file Form OR-24 every year after selling the Oregon property through a 1031 exchange until the deferred gain is finally reported and taxed. Unlike California and Oregon, Massachusetts and Montana do not have an annual filing requirement.

Property Market Differences

Every market has its own unique rules, trends, and challenges. What worked in Illinois may not work in Vermont or Washington. So, before venturing into a multi-state exchange, you have to be properly informed of the differing zoning laws, transfer taxes, and escrow norms across states. 

Also, endeavor to understand the local property values and trends, land use, rental use, future development plans of the area, and so on. Improper knowledge of the various markets of each state could result in you overpaying or investing in a property that does not perform as expected. 

Legal and Compliance Requirements

Each state has its real estate laws, closing procedures, and other related practices that you must abide by to avoid local penalties. Keeping the IRS guidelines and rules is also non-negotiable when carrying out an out-of-state exchange. 

In addition, certain states may require additional documentation or annual filings after the exchange. All these can be overwhelming, but a good QI will help you ensure due compliance with both federal and local requirements while preserving your tax-deferral status. 

Know the Reporting Requirements in Both States

One of the major benefits of proper reporting is that it shows whether the 1031 exchange is properly structured and IRS-compliant. It also protects you from elements of surprise like unexpected tax bills, clawbacks, exchange disqualification, and the rest.

States like California require specific reporting, such as the Form FTB 3840 we discussed, and strict compliance requirements for exchanges. Others, like Oregon and New York, require investors to file non-resident returns and continuous reporting until tax deferral ends and payment is required. 

As such, it’s crucial to keep a well-detailed document of your deferred gain, new property basis, and any depreciation adjustments during the exchange to prepare you for future tax events, whether you later sell, perform another exchange, or ultimately cash out. 

Pick a QI With Multi-State Exchange Experience

A Qualified Intermediary is simply someone who acts as a middleman during a 1031 exchange. The QI is responsible for facilitating a relinquished property sale, holding the proceeds, and acquiring a new like-kind property on behalf of an investor.

They also keep a well-detailed report of the entire exchange process, ensuring long-term compliance with tax laws at both the state and federal levels. Because each state has its own regulations and tax code, it is necessary to always work with a QI with a proven track record of handling multi-state exchanges in the jurisdiction of your choice. 

It’s also noteworthy that exchanges always attract various expenses, such as escrow, legal, exchange, administrative, and Qualified Intermediary fees. A good QI should help you get the best deals to bring these fees down to the barest minimum. Book a free consultation now to discuss with a reputable QI.

When You Should Avoid an Out-of-State 1031 Exchange

It is advisable to avoid an out-of-state 1031 exchange when you have limited or no experience in the new market you intend to acquire the replacement real property as this could result in increased buyer risk. These risks may include: income deferral loss, inability to meet the IRS deadline, difficulty finding the right replacement property, and even overpaying for the property.

Also, buying new like-kind properties in regions with high state taxes and strict requirement standards could put your deferred taxation at risk if not handled properly. A little mistake, like missing a form or deadline, can trigger taxes you were hoping to defer. 

Best Practices for Cross-State Exchanges

A multi-state 1031 exchange is a valuable tool utilized by most investors to unlock new investment opportunities, however, this can only be made possible if the transaction is successful. There are certain best practices to help you execute a perfect and seamless multi-state exchange. 

1. Work With an Experienced Qualified Intermediary

As stated earlier, a QI is required for a 1031 exchange to be considered valid. The QI will help you navigate the exchange process with confidence and ensure everything goes smoothly. Nonetheless, professional knowledge of who handles your 1031 exchange is essential, as the success of the exchange is largely dependent on the individuals involved. 

2. Consult a Tax Advisor Familiar With Multi-state Filings

Because each state has its own unique tax rules, a tax professional is needed to guide you on state-specific filing requirements, deferred gain tracking, and basis calculations for future transactions.

And so, working with a financial advisor who understands both federal 1031 rules and the tax laws of multiple states can offer guidance on non-resident tax returns, basis adjustments, and clawback provisions. They help ensure that your exchange remains long-term compliant and your tax-deferral status is maintained.

3. Research the Target Market Thoroughly

Before purchasing a replacement property in a new state, it is important to take time to research the new market thoroughly to gain a proper understanding of the local property values, rental demand, tenant laws, zoning restrictions, growth trends, and economic outlook. A proper knowledge of all these can help prevent surprises along the way. 

4. Proper Documentation and Adherence to IRS Deadlines

You have only 45 days to identify a replacement property and a total of 180 days to finalize the deal. The IRS is strict with these deadlines and will not hesitate to disqualify your transaction if you default.

As you race to meet the deadlines, keep proper records of your contracts, settlements, adjusted basis, depreciation recapture, and all paperwork that will help you defend the legitimacy and compliance of your exchange during any IRS scrutiny.

Want to Ensure a Smooth State-to-State 1031 Exchange?

Although performing a 1031 exchange for different states is possible, you must be fully aware of the rules governing each of the states and how to effectively adhere to them. Likewise, it is vital to work with a QI well-versed in multi-state exchanges to avoid surprises or errors that may spring up along the way. 

Universal Pacific 1031 Exchange is one of the leading Qualified Intermediary service providers in Los Angeles with in-house licensed Certified Public Accountants. We are renowned for helping new and old investors navigate the world of 1031 exchanges while making smart and better investment choices. 

Let’s help you conduct your interstate 1031 exchange with ease. Walk into our 1031 exchange office in Los Angeles to start a 1031 exchange now. 

FAQs

Can I Live in the New Property If It’s in a Different State?

Not right away, at least not if you want to fully defer capital gains taxes. Under IRS rules, 1031 exchanges are strictly for investment or business properties, not personal residences. This simply means that the asset you acquired through the exchange, even if it’s in another state, must be rented out as an income property for at least two years before living in it. You can take a look at this article for a better understanding.

Are Vacation Rentals Eligible for 1031 Exchanges Across States?

Yes, vacation rentals can qualify for a 1031 exchange across state lines so long as they are held primarily for investment purposes and not personal use. Under IRS guidelines, the asset must be rented out typically for at least 14 days per year, and personal use must be limited (no more than 14 days or 10% of rental days annually).

Which States Do Not Recognize 1031 Exchanges?

Technically, all 50 states of the U.S. recognize 1031 exchanges. Formerly, Pennsylvania did not permit taxpayers to defer state taxes through a 1031 exchange, only federal taxes could be deferred. This changed on July 8, 2022, when House Bill 1342, which recognizes 1031 at the state level, was signed into law by Pennsylvania Governor Tom Wolf.