Can You Do a 1031 Exchange Into Another State?

Yes. For federal purposes, real property held for investment or business use anywhere in the United States is like kind to real property held the same way in any other state. You can sell a rental in one state and buy replacement property in another without breaking the exchange. What changes is the state paperwork on each side, and in a few states, what happens to the deferred gain years later.

Does the replacement property have to be in the same state?

No. Section 1031 looks at the nature of the property, not its location within the country. An apartment building in one state can be exchanged for a warehouse, a retail building or raw land in another. The same holding requirement applies wherever the property sits: both the property you sell and the property you buy must be held for investment or for use in a trade or business.

The one location rule that does matter at the federal level is the national border. Real property in the United States and real property outside the United States are not like kind to each other. Moving from one state to another is fine. Moving from a state to a foreign country is not.

Why do owners exchange across state lines?

The reasons are usually practical rather than tax driven. Common ones include:

• ›Moving closer to family or to a planned retirement location, so the property is easier to oversee
• ›Leaving a market where prices, regulation or management demands have become harder to live with
• ›Wanting a different property type that is more common in another region
• ›Simplifying from several local properties into one that suits a different stage of life

What can the state you are selling in require?

The state where the relinquished property sits may have its own rules at closing and afterward. Two are worth asking about early.

Nonresident withholding. Some states require a percentage of the sale price or gain to be withheld at closing when the seller does not live in that state. Many of those states offer an exemption or reduced withholding for a qualifying exchange, but it usually requires a specific form filed on time. If the form is missed, money that should have gone to your Qualified Intermediary can be withheld instead, and that shortfall can create a taxable gap in the exchange.

Tracking the deferred gain. A small number of states, including California, Massachusetts, Montana and Oregon, have rules that follow deferred gain out of state. California, for example, requires an annual filing when California property is exchanged into property elsewhere, and it expects to tax its share of the original gain when the replacement property is eventually sold in a taxable sale. Your gain is deferred, but the original state has not forgotten it.

What does the state you are buying in change?

The replacement property brings its own state rules with it. Things to raise with your advisers include:

• ›State income tax on rents. Rental income is generally taxed by the state where the property is located. Owning in a new state can mean filing a nonresident return there each year.
• ›Transfer and recording taxes. These vary widely, and a 1031 exchange usually does not exempt you from them.
• ›Property tax. Rates, assessment practices and reassessment on purchase differ from state to state, which affects your operating costs.
• ›Landlord and tenant law. Notice periods, deposit rules, eviction procedure and rent regulation differ, sometimes sharply.

A handful of states, such as Texas, Florida and Nevada, have no personal income tax. That can change the annual picture on rents, but it does not erase any claw back that the state you sold in may still apply later.

An illustrative example

Here is a simplified, illustrative example. The figures are not a projection and ignore costs and debt.

An owner sells a rental in a state that tracks deferred gain. The sale produces $400,000 of gain, all deferred into a replacement property in a state with no personal income tax. For federal purposes the deferral works the same as it would for an in state exchange. Each year, the owner files the tracking form the original state requires. Ten years later, the owner sells the replacement property in a taxable sale. Federal tax applies to the deferred gain plus any new gain. The original state may also expect tax on its share of the $400,000, even though the owner no longer has property there. How much, if any, depends on that state's rules at the time.

The point is not that the move was a mistake. It is that the state side of the decision should be understood before closing, not discovered afterward.

Do you need a Qualified Intermediary in the new state?

Not usually. Many Qualified Intermediaries handle exchanges nationally, and the intermediary does not have to be located where either property sits. What you do need is a closing process in each state that the intermediary is comfortable working with. Some states close through escrow companies, and others customarily use attorneys. Your intermediary should be engaged before the relinquished property closes, wherever the replacement property ends up.

What about buying through a new LLC in the new state?

Owners buying out of state sometimes set up a local entity for liability reasons. The federal same taxpayer rule still applies: the taxpayer who sells must be the taxpayer who buys. A single member LLC that is disregarded for federal tax purposes is generally treated as its owner, so buying through one is often workable. A new multi member LLC or a partnership is a different taxpayer. Confirm the vesting with your Qualified Intermediary and CPA before you sign the purchase contract.

Is the 45 day window harder when buying far away?

Often, yes. Identifying property in a market you do not know, arranging inspections, reviewing leases and lining up financing from a distance all take time, and the 45 day and 180 day deadlines do not stretch to accommodate travel. Owners who plan an out of state exchange usually start researching the destination market well before the sale closes, and many identify backup properties in case the first choice falls through.

Some investors look at fractional structures, such as Delaware Statutory Trust interests, as one way to hold property in other states without managing it directly. DST interests are securities, available only to accredited investors, and are offered through a licensed broker dealer and definitive offering documents. Investing involves risk, including loss of principal. Whether any approach fits your situation is a question for your own advisers.

Bringing it together

A 1031 exchange can cross state lines, and many do. The federal rules are the same wherever the property sits within the country. The work is on the state side: withholding forms at closing, any ongoing tracking of deferred gain, new state filings and a different set of local rules for the property you buy. Tell your CPA and Qualified Intermediary early where both properties are located, so those pieces are handled on time.