Tax Consequences of a 1031 Exchange

Maximizing your Tax Deferral

Generally, to maximize your tax deferral, you must acquire replacement property of equal or greater value and equity. The value of the relinquished property is its net selling price which is the contract sales price less routine transaction expenses. The equity in the relinquished property is the net after all routine transaction expenses and mortgage payoff(s). A trade down in value or equity creates a taxable event known as “boot.”  You are taxed on the greater trade down (value or equity). You should always discuss your situation with a tax and/or legal professional before proceeding with a 1031 exchange.

Deferral of State Gain

Most states recognize 1031 exchanges allowing the deferral of the state gain as well. However, there are a few states (including the Commonwealth of Pennsylvania) that do not recognize an exchange and some that have special requirements (such as acquiring replacement property within the same state). Other states have no income tax.

Note that Pennsylvania imposes state income taxes on all resident taxpayers as well as any non-resident taxpayer that makes money in the Commonwealth. Pennsylvania residents that sell in Pennsylvania or anywhere else are required to pay Pennsylvania income tax. Non-residents taxpayers selling property in Pennsylvania are required to pay Pennsylvania income tax on the profits even if the taxpayer can complete in a 1031 exchange in their home state or if there is no income tax in their home state.

See Recent Newsletter Article about PA Income Tax 

Non-Resident Withholding Tax

Many states have enacted mandatory non-resident withholding taxes that must be withheld at the time of sale if the seller is not a resident of that state. Closing agents in these states must submit a check representing the required withholding tax to the Recorder of Deeds in order to have the Deed recorded. When completing a 1031 exchange, the Taxpayer may file for an exemption but most states require this be completed prior to closing. 

The following States currently have non-resident withholding requirements:  California, Colorado, Delaware, Georgia, Hawaii, Maine, Maryland, Mississippi, New Jersey, New York, North Carolina, Rhode Island, South Carolina, Vermont, Virginia and West Virginia. Keep in mind other States may enact laws requiring a non-resident withholding tax. 

Pulling Cash OUT Tax-Free

After the exchange is complete, many advisors believe a loophole in the regulations enables you to refinance and pull cash/equity out of the replacement property, tax-free. Advisors suggest it is wiser to pull the cash out after the exchange is complete than to pull the cash out on the relinquished property prior to or immediately preceding the sale. Your tax advisor can help you determine what is best in your situation.

Basis of Replacement Property

The basis of the replacement property is lowered by the deferred gain. Essentially, the old basis is carried to the new property and increased by any additional property value acquired.

Depreciation of the Replacement Property

The basis of the replacement property acquired in a 1031 exchange is generally the same as that of the relinquished property less any cash received plus any gain recognized. Notice 2000-4 clarified how MACRS replacement property in a 1031 exchange should be depreciated. The MACRS replacement property should be treated in the same manner as the MACRS relinquished property with respect to your basis in the replacement property provided it does not exceed the adjusted basis in your relinquished property. The replacement property is depreciated over the remaining recovery period, and using the same depreciation method and convention as that of the relinquished property. Any excess basis in the replacement property is treated as newly acquired MACRS property. There will generally be at least two different depreciation schedules in place on one asset. Notice 2000-4 applies to properties placed into service on or after January 3, 2000. T.D. 9115 (2/27/04) is a clarification of Notice 2000-4 and gives you the option to elect out of this depreciation treatment.