One of the signature rules in a 1031 Exchange is that the property owner must reinvest the sale proceeds from their “relinquished property” into a like-kind “replacement property.” This requirement is relatively benign on its face, but competition for the best replacement properties can be significant, which may lead investors to expand their search criteria outside of their own local market. So, this leads to a commonly asked question, can an investor complete a 1031 Exchange from one state to another?
In this article, we are going to explore the answer to this question. In doing so, we will explain how state to state exchanges work, describe some of the complications of doing them, and discuss how working with a private equity firm can make them easier. By the end, readers will have the information needed to determine if this type of transaction is a good fit for their individual needs.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers and, as part of this effort, we frequently work with individuals looking for a suitable 1031 Exchange Replacement Property. If you are an Accredited Investor and would like to learn more about how we can help facilitate a 1031 Exchange, click here.
What is a 1031 Exchange?
In order to understand how a state to state 1031 Exchange works, it is first helpful to review a few key facts about them.
A 1031 Exchange – sometimes called a Deferred Exchange or Like Kind Exchange – is a type of commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the sales proceeds into another “like kind property.” To receive full tax deferral, Internal Revenue Code (IRC) section 1031 lays out a number of key rules that investors must follow. They include:
- Within 45 days of the sale of the Relinquished Property, investors must identify – in writing, the Replacement Property that they plan to purchase
- Within 180 days of the sale of the Relinquished Property, investors must close on the purchase of the identified Replacement Property.
- The value/sales price of the Replacement Property/exchange property must be the same or greater than the Relinquished Property. In addition, the debt and the equity invested must also be the same or greater.
In many cases, investors like to look for a Replacement Property in the same market in which they live. But, they may find that the options are not to their liking, which may result in an expansion of the search criteria – including out of state.
How State to State 1031 Exchanges Work
A “state to state 1031 Exchange” is one where the Relinquished Property and the Replacement Property are in different states. For example, an individual could sell an apartment building in Florida and purchase one in Colorado, New Jersey, Massachusetts, or California and this would be a state to state 1031 Exchange.
This sort of exchange transaction is entirely permissible under 1031 Exchange rules, but they can also come with a number of potential complications.
Potential State to State 1031 Exchange Complications
The key point here is that the rules that allow a 1031 Exchange are made at the federal level so they supersede state laws. However, there may be state specific rules and laws that are not covered in the federal tax code and investors must navigate these depending on the state in which they live and/or transact business.
Claw Back Provisions
Some states have laws that allow them to “claw back” taxes on the profitable sale of a property. In other words, they have the ability to assess taxes on any gain in property value accrued and realized through a profitable sale. For example, suppose an investor sold a property in California (which has state income taxes) and purchased a replacement property in Florida (which does not have state income taxes). When the Florida property is sold, California may “claw back” taxes on the gain in addition to anything that may be due on the Federal level.
States with claw back provisions include California, Massachusetts, Montana, and Oregon.
State of Residency and Withholdings
If the real estate investor lives in a state with no income tax – like Texas – and owns a property in a state that does have income tax – like New York, they may be required to withhold some amount of money for state taxes.
It should be noted that, if the situation was reversed, the same may not apply. For example, if an investor lived in New York, but sold a property and Texas, they may not be subject to the same state withholding requirements. There may be exemptions available depending on the circumstances of the transaction.
Pennsylvania
Of the 50 states, Pennsylvania is the only one that does not recognize this tax deferral program. So, if a Relinquished Property is sold in Pennsylvania, the property owner may be subject to state level capital gains taxes on their real estate investment.
Perhaps the broader point here is that exchanging from a property in one state to a property in another state brings additional state level complexity with regard to the tax treatment of the transaction. For this reason, it is always a good idea for real estate investors to seek tax and/or legal advice from an individual with expertise in both state and federal level tax rules. This person could be a CPA, tax advisor, or Qualified Intermediary/Exchange Facilitator who has 1031 Exchange specific expertise.
Private Equity Real Estate and 1031 Exchanges
From this article, it can be seen that a 1031 Exchange is a complicated transaction and it can become more so when it involves properties in multiple states. For this reason, individual investors may have some hesitation about approaching this type of transaction on their own.
In such cases, working in partnership with a private equity firm can provide a compelling alternative. In this type of arrangement, an individual investor is able to purchase a fractional share of an institutional quality Replacement Property (in another state if they want) using a “tenants in common” ownership structure. This both makes finding the Replacement Property easier and allows the real estate investor/tax payer to benefit from the expertise and resources of the private equity firm.
Summary of Performing a 1031 Exchange Across State Lines
A 1031 Exchange is a type of commercial real estate transaction that allows investors to defer capital gains taxes as long as they reinvest the sale proceeds from the Relinquished Property into a new, like kind Replacement Property.
Typically, investors like to look for Replacement Properties in their own local market or within the same state as the Relinquished Property. But, this is not always possible so it may be necessary to look for properties that are in a different state.
While looking for a Replacement Property in another state is perfectly permissible under IRS rules, there may be state specific nuances that investors should be aware of. These include claw back provisions, tax treatment for nonresident investors, and the knowledge that Pennsylvania does not recognize tax deferred exchanges.
Given the complications within a state to state exchange, it may be a good idea for investors to consider working with a private equity firm who can help with the logistics in this type of transaction.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners.
If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
