State Tax and 1031 Exchanges
A 1031 exchange gets its name from section 1031 of the Internal Revenue Code. This tax-deferral strategy is part of the FEDERAL tax code. Whether or not you can defer the state gain varies by state.
Several states have no state income tax so there is no need to report the exchange on a state return. Other states follow the federal tax code so you can defer the state gain through your 1031 exchange. A few still have quirks that you must buy a replacement property in the same state the relinquished property was located. And then there is Pennsylvania. The Commonwealth of Pennsylvania does not recognize 1031 exchanges so while you will defer the federal gain, you will have to pay the Pennsylvania income tax. For PA residents who sold property (anywhere) or non-residents that sold property in PA, the 2010 tax rate for individuals is 3.07%. Note you must typically file a state return where the relinquished and replacement properties are located as well as your resident state.
In recent years, many states have implemented a mandatory non-resident withholding tax that must be paid when property is transferred to a buyer. Those closing agents handling the conveyance to the buyer are required to withhold a certain percentage of the gross sales price in order to get a deed recorded. If you are doing a 1031 exchange, it maybe possible to obtain an exemption from the state but in most cases, you must apply for the exemption prior to the closing of your relinquished property. Some of the states that have a non-resident withholding tax and allow you to file for the exemption include:
- New York
- North Carolina
- Rhode Island
- South Carolina
- West Virginia
New Jersey also has a mandatory withholding tax for non-resident sellers. However, there is no need to request an exemption. With the simplest of all withholding requirements, sellers can simply complete the Nonresident Seller’s Tax Declaration right at your closing. The closing agent will instruct you to check the box on number 7 and circle 1031.
If you received the exemption, you must file a state tax return to report your exchange.
Note that some states refuse the exemption if the seller has not been filing a state return to report the income and expenses associated with the relinquished property.
Your 1031 CORP. exchange officer is always available to answer questions regarding the non-resident withholding tax.