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A New York 1031 Tax Issue Primer

When a 1031 exchange occurs, one point to keep in mind is that it may generate state level tax issues. 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.

A few states in our nation currently do not collect a state income tax. Section 1031 exchanges performed in them obviously won’t trigger state tax issues.  But most states, such as New York, do impose a state income tax. In them, 1031 exchanges either trigger a corresponding state tax, or require documentation showing the inapplicability of the state tax.  This article focuses on New York 1031 like kind exchanges. In it, we’ll look at the unique issues presented by the New York State tax code. In particular, we’ll look at deferring both federal and state liabilities in a New York 1031 exchange conducted within the State’s borders. 

General Overview of New York Tax Issues

The simplest way to introduce the many state tax issues pertaining to Section 1031 is to state 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 apply one of five strategies. Some use federal taxable income as a stepping stone to calculate state income tax. Others adopt the IRC’s methods for computing state income tax. Still others entirely disallow the tax deferral benefits of Section 1031. Some require reinvestment strictly within the borders of their state. Some others use a clawback provision. Let’s take a look.

No Tax Deferral in PA

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%).

The California Clawback

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 New York nonresident conducts a New York 1031 exchange using a relinquished property within New York, this person faces a state income tax rate of 7.7%. This would apply to the gain realized from the sale. Fortunately, however, New York nonresidents selling property as part of an exchange can file for an exemption from this withholding. When a New York nonresident sells New York real estate, there’s a “mandatory withholding”. This is required 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’re 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 large tax liabilities, the appeal of the clawback provision is clear. 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, both the New York State and NYC Departments of Taxation and Finance conclude that “reverse exchanges” don’t trigger the Real Estate Transfer Tax (RETT). That’s normally triggered by the receipt of New York real estate. Both departments base this on the fact that, in reverse exchanges, replacement property is acquired by an EAT. That is, an “exchange accommodation titleholder”. It’s then transferred out of this same entity. So, in this exchange variation, technically the taxpayer doesn’t purchase the replacement property. Instead it first funds the EAT. It then simply receives the deed following the sale of the relinquished property.

Call Us For Assistance!

Clearly, there’s enough complexity to these tax issues to warrant consultation with an experienced New York tax attorney. Ideally, that happens prior to conducting your New York 1031 like kind exchange. It’s always a good idea to speak with a qualified tax professional. They provide experienced guidance and can assist in your particular transaction. If you’re preparing to for a New York 1031 exchange, please get in with us. One of the tax attorneys at Mackay, Caswell & Callahan, P.C. can help you today!

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