When a taxpayer conducts a 1031 exchange, one point which should always be kept in mind is that this transaction may generate issues with state level taxation. Though it’s part of the federal tax code, Internal Revenue Code (IRC) Section 1031 can trigger state taxation depending on the precise facts and circumstances of the individual transaction. There are a few states in our nation which currently do not collect a state income tax, and so 1031 exchanges performed in those states obviously won’t trigger state tax issues, But in states, such as New York, which do impose a state income tax, 1031 exchanges will either trigger a corresponding state tax liability, or require that documentation be submitted to show the inapplicability of the state tax. This article will focus on New York 1031 like kind exchanges and the unique issues presented by the State’s tax code.
As you’re no doubt aware, the great State of New York imposes a state income tax (along with plenty of other types of taxes, as we’ve explored) on its residents and so this tax will surface whenever a New York taxpayer sells New York real estate as part of an exchange. However, New York taxpayers are permitted to defer this state tax when they conduct a New York 1031 exchange, accordingly, it’s possible to defer both federal and state liabilities when conducting a New York 1031 exchange within the State’s borders.
General Overview of New York 1031 Tax Issues
The simplest way to introduce the many state tax issues pertaining to Section 1031 is to say the following: whatever issues you encounter will depend on the facts of your individual transaction. As mentioned, you may end up conducting your exchange in a state with zero state income tax or a state with a relatively straightforward exemption procedure. But though this is the case, there are a few issues which tend to show up more frequently than others.
With regard to 1031 exchanges in general, states either use federal taxable income as a stepping stone to calculate state income tax; adopt the IRC’s methods for computing state income tax, disallow the deferral benefits of 1031; require reinvestment strictly within the state, or use a clawback provision.
Again, each state handles things a bit differently, and so it’s imperative that you check the specific requirements for the state (or states) in which you plan to conduct your 1031 exchange. The Commonwealth of Pennsylvania, for instance, doesn’t recognize the tax deferral benefits provided at the federal level for 1031 exchanges; so if a resident (or nonresident) of Pennsylvania sells an investment property located within the commonwealth, they’ll necessarily be liable for state income tax (currently at a rate of 3.07%).
California, on the other hand, provides a perfect example of a state which uses a so-called “clawback” provision to aggressively attempt to recapture lost state taxes. If a person, resident or nonresident, decides to sell their California property and then acquire a non-California property as replacement property, then the California Franchise Tax Board will collect (or clawback) the state tax liability which would have followed if a straight sale of the original California property had been made. In other words, just because someone conducts an exchange on a California property and acquires an out-of-state property doesn’t mean that they can completely escape the California state income tax, because this tax will be triggered the moment the taxpayers performs a traditional sale. The state of California even requires that taxpayers annually file a form in order to prove that they haven’t cashed out their property and aren’t currently liable for the tax.
New York 1031 State Tax Issues
If a nonresident of the State of New York conducts a New York 1031 exchange using a relinquished property within the borders of New York, this person would face a state income tax rate of 7.7% (which would apply to the gain realized from the sale). Fortunately, however, non-residents who sell a New York property as part of an exchange can file for an exemption for this state tax withholding. When a nonresident of New York sells a piece of New York real estate, there is a “mandatory withholding” which must be taken out unless the nonresident applies for the exemption. Filing the exemption is fairly simple: nonresidents fill out New York Form IT-2663 and then indicate that they are using the property in a tax-deferred like-kind exchange.
What this means in practice is that if a nonresident sells their New York property, receives the exemption, and then reinvests their proceeds in a piece of real estate located in, for example, Rhode Island, then the gains attributable to the New York property will never be subject to New York State taxation. Given that these gains can oftentimes result in extremely large tax liabilities, it’s easy to see the appeal of the clawback provision. At the present time, however, no such clawback rule appears to be on the horizon in New York.
New York State & City Transfer Taxes for Reverse Exchanges
Importantly, it’s worth noting that both the New York State and New York City departments of taxation and finance have concluded that “reverse exchanges” will not trigger the Real Estate Transfer Tax (RETT) which is normally triggered by the receipt of New York real estate. These departments have both based this conclusion on the fact that, in a reverse exchange, the replacement property is both acquired by an “exchange accommodation titleholder” (or EAT) and then transferred out of this same entity. So, in this exchange variation, technically the taxpayer doesn’t purchase the replacement property, but instead first funds the EAT, and then simply receives the deed following the sale of the relinquished property.
Clearly, there is enough complexity to these various state tax issues to warrant a consultation with an experienced New York tax attorney prior to conducting your New York 1031 like kind exchange. No matter how firm a handle you feel you have on this type of transaction, it’s always a good idea to speak with a qualified tax professional who can provide experienced guidance for your particular transaction. If you’re preparing to perform an New York 1031 exchange any time soon, please get in touch with one of the tax attorneys at Mackay, Caswell & Callahan, P.C. today!