Caution: State Taves vs. 1301

Robbie Robertson, S.E.C. recently shared a report he had read that made it clear that, as real estate investors and exchangors, we need to be knowledgeable about the state-by-state tax aspects of like-kind exchanges of real estate.

In most states, 1031 exchange transactions that are exempt from federal income tax are also exempt from state tax ramifications. In those states, the state tax law closely parallels the federal tax code. However, pitfalls exist in a number of states. For example, the states of Georgia, Mississippi, and Vermont, each impose tax liabilities on real estate exchanges if out-of-state property is involved. Another state, Indiana, bars deferred exchanges involving intermediaries from tax-free treatment.

Hal Morrison, S.E.C. reports that he had a personal experience that illustrates this point. Hal was a Virginia resident and owned a property in South Carolina he was exchanging. He could have completed a fully tax deferred exchange with respect to South Carolina real estate taxation if his replacement property had been in South Carolina. The state would still have direct access to the deferred gain at some later date (if sold). However, Hal’s replacement property was located in Georgia, so he had a South Carolina tax liability in that tax year. Clearly, South Carolina wanted to tax the gain in the year it occurred, since the deferral would be “lost” in the paperwork shuffle over multiple tax years. They may have also been concerned that if Hal moved out of state, South Carolina might not be able to enforce reporting by a non-resident. Therefore, at settlement and closing of the relinquished property transaction in South Carolina, Hal had to sign affidavits for the state of South Carolina, in order for the state to track the transaction through that tax year.

Word of Caution: As a real estate investor and exchangor, your best defense is to check with your tax adviser before you set up a like-kind exchange involving out-of-state property so you don’t inadvertently create a state income tax liability that might have been avoided with proper tax planning.

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