Beware of State Clawbacks when Using Section 1031

Edmund Wheeler 1031 State ClawbackWe have conditioned our clients to expect that state capital gains tax can be deferred along with the federal tax exposure by utilizing Section 1031 for their exchanges. It is true, most states will honor the deferral as long as the gain is being rolled into the new property.

However, you should be aware that not all states recognize Section 1031 in the same manner as the Federal Tax Code. Recognizing the subtleties can be the difference between tax deferral in future years or tax liability. Increasingly, our clients have become tax savvy and have begun selecting their replacement properties in states that have the most favorable tax treatment. A few tax hungry states have begun instituting a “clawback” provision that entitles the taxing authority in the departing state to go after the tax it would have otherwise collected if the exchanger eventually “cashes out”.

The State of California has enacted legislation that will go into effect on January 1, 2014 that will require an exchangor departing the state to file an annual information return, regardless of the taxpayer’s state of residency. The purpose of the filing is to to be sure that the deferred state tax is still applicable and that the taxpayer has not in a subsequent year “cashed-out” thereby denying the deferred state tax.

Unfortunately, California is just the latest state to enact the “clawback”. Massachusetts, Montana and Oregon also have indicated that they will pursue taxpayers who received deferrals and later cash out. These three states have not made it clear how they will monitor and collect but as budgets continue to be strained, expect that there will be no hiding places left!

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