Can You Do a 1031 Exchange Between States?

By Edward E. Fernandez | February 5, 2024

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A 1031 exchange enables investors to relinquish one investment property for another and defer capital gains tax in the process. Through this transaction, investors must identify a like-kind replacement property of equal or greater value and reinvest the proceeds from the sale into that property to benefit from deferred taxes.

Taxpayers must also adhere to strict timelines for this transaction and use a neutral party called a Qualified Intermediary (QI) during the exchange. If you’re considering performing a 1031 exchange, you might be wondering whether your relinquished property and the replacement property can be in different states. The short answer is yes! Learn more about how to perform a 1031 exchange between states, the limitations, exceptions, and best practices.

How Investors Can Perform a 1031 Exchange Between States

According to IRS rules, you are permitted to perform a 1031 exchange between states as long as the properties qualify as like-kind. However, you cannot exchange a U.S. property for a foreign one, or vice versa — both must be in the United States.

Let’s assume you’re looking to perform a 1031 exchange in the U.S. but want to acquire a replacement property in a different state. This is known as a state-to-state 1031 exchange, also known as a 1031 exchange between states. This transaction doesn’t differ much from a traditional 1031 exchange. Because 1031 exchanges are made at the federal level, the treatment is often the same across most states. Many states — but not all — closely follow the federal process of tax deferral benefits and reporting for 1031 exchanges.

According to IRS rules, you are permitted to perform a 1031 exchange between states as long as the properties qualify as like-kind.

However, it’s important to note that some states may have specific laws, regulations, or nuances that are not covered by the IRS tax code. For example, before 2023, Pennsylvania did not recognize tax-deferred exchanges. Investors must perform their due diligence if they wish to conduct a 1031 exchange in different states where they are unfamiliar with the rules.

Before we get into the potential complications and considerations of a state-to-state 1031 exchange, let’s look at a brief example of what this transaction can look like. Suppose you’ve invested in an apartment complex in Arizona, where you reside. After doing some market research, you haven’t found any like-kind properties in Arizona that meet your needs. You soon find the perfect replacement property located in Connecticut. As long as you adhere to the 1031 exchange requirements and the laws regarding a like-kind exchange in both Arizona and Connecticut, you should be able to complete the transaction and defer capital gains tax successfully.

Limitations and Exceptions for State-to-State 1031 Exchanges

Though you can do a 1031 exchange out of state, there are certain restrictions and exemptions to be aware of. If you’ve never performed a state-to-state 1031 exchange before, here are some key considerations to remember to make a well-informed decision.

Clawback Provisions

Some states have what’s known as clawback provisions, or exceptions, to out-of-state 1031 exchanges. These states are:

  • Oregon
  • Montana
  • California
  • Massachusetts

If the relinquished property is in these states, they will collect taxes on the sale of the replacement property if the investor sells it in a taxable sale in the future. Since the state where the replacement property is will also collect taxes, investors can get double-taxed.

For example, you sell a retail property in California, initiating a 1031 exchange to defer capital gains on the sale. Following this, you purchase an office building in Indiana to replace the one you sold. After some time, you sell the Indiana property for a capital gain. Because of your previous ownership in California, you are now liable to pay capital gains taxes in both Indiana and California.

Some of these states may also require investors to file annual returns for as long as they hold the property.

Withholding Requirements and Exemptions

Withholding requirements of state-to-state 1031 exchanges refer to the obligation to withhold capital gains taxes. These mandatory tax withholdings are only applicable to non-resident or non-U.S. taxpayers. While these requirements are at a federal level, it is important to note that some states have their own withholding regulations for real estate transactions. Exemptions vary between states and may include using proceeds for like-kind exchanges, transactions below a specific threshold, or when the property is the seller’s primary residence.

Best Practices for Investing With a 1031 Exchange Out of State

1031 exchanges can provide several advantages if the transaction is successful. Here are some tips for making the 1031 exchange across state lines as seamless as possible.

  • Define your investment goals: Determine what you’re looking for in your next investment property. Do you want to go from a single-family investment home to a multifamily property? A senior living care facility to a strip mall? Set your objectives so you can narrow down your property identification process.
  • Do your research: Before searching for new properties, ensure you thoroughly comprehend the 1031 exchange process and its requirements. Knowing the rules can help you meet your goals, maximize your returns, and prevent your exchange from being disallowed.
  • Assess the financial implications: As with any investment, particularly one out of state, it’s important to consider the capital gains tax rates, tax implications, savings, financing options, exchange fees, and other expenses that go into the process. This assessment can help you understand the expected benefits and feasibility of the transaction.
  • Engage a Qualified Intermediary: A QI is required for a valid 1031 exchange. They will oversee the transaction for you, create exchange documents, sell the property on your behalf, and keep the funds acquired from the sale in an escrow account until you are ready to reinvest into your replacement property. Consulting with a QI and other experienced professionals can help you navigate the intricacies of the exchange process and ensure everything is done correctly.
  • Stay ahead of the timeline: Investors have 45 days to identify a replacement property and 180 days to close on the property from the day they close on the sale of the relinquished property. This time can easily fly by, so be sure to meet those deadlines to avoid losing your tax deferral benefits.

View 1031 Exchange Replacement Properties With 1031 Crowdfunding

A 1031 exchange can pave the way for further investment opportunities by helping you keep more funds available for reinvesting. As part of your due diligence, ensure you understand the nuances of the state you may want to exchange into. At 1031 Crowdfunding, we assist investors through 1031 exchanges and other investment vehicles focused on tax deferral. 

Our experienced team of securities and real estate professionals will guide you through our online marketplace of vetted 1031 exchange properties where you can view all the documents and details you need to make a well-informed decision. Register for an investor account today to learn more about how we can help you invest with confidence.

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This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.

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