Which States Do Not Recognize 1031 Exchanges?

A 1031 exchange, often referred to as a like-kind exchange, permits real estate investors to defer capital gains taxes when they sell an investment property and reinvest the proceeds into another similar property. This provision, outlined in Section 1031 of the Internal Revenue Code, applies to real property held for productive use in a trade or business or for investment. The core benefit involves postponing the recognition of taxable gain, allowing investors to maintain more capital for reinvestment and wealth accumulation. While this is a federal tax deferral mechanism, individual states adopt varying approaches to its application within their own tax codes.

States Conforming to Federal 1031 Rules

The majority of U.S. states, including the District of Columbia, generally align their income tax laws with the federal treatment of 1031 exchanges. This means that if an exchange qualifies for federal tax deferral, it also qualifies for state income tax deferral in these jurisdictions. Most states broadly recognize the concept of like-kind property as defined by federal guidelines, allowing for exchanges of various types of real estate, such as commercial property for raw land, so long as both are held for investment or business purposes. This widespread conformity simplifies the process for many investors, as the federal rules often serve as the primary framework for state-level tax deferral.

States Not Conforming to Federal 1031 Rules

While many states mirror federal 1031 exchange provisions, some jurisdictions either do not have a state income tax, making the concept of conformity irrelevant for income tax purposes, or they implement specific modifications that diverge from federal treatment. Nine states currently do not impose a statewide income tax, which includes Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. In these states, there are no state income taxes to defer through a 1031 exchange, as capital gains are not taxed at the state level. It is important to note that Washington state does impose a capital gains tax, but it is not structured as a general income tax.

Beyond states with no income tax, several others have unique provisions that affect the long-term deferral of gains from 1031 exchanges. California, Oregon, Montana, and Massachusetts implement “clawback” provisions. These rules allow the state to retain the right to tax the deferred gain, even if the replacement property is located outside their borders. The deferred gain remains attributable to the original state, and the tax liability may eventually materialize when the 1031 exchange chain is broken by a taxable sale.

California, for instance, requires taxpayers to file an annual information return, Form FTB 3840, to track deferred gains from California-sourced property that has been exchanged for out-of-state property. Similarly, Oregon mandates annual reporting via Form 24 for deferred gains originating from relinquished Oregon property.

Montana and Massachusetts also have clawback provisions, but they generally do not impose an annual filing requirement to track these deferred gains. Pennsylvania now recognizes 1031 exchanges for state income tax purposes as of January 1, 2023, aligning its treatment with federal law.

State-Level Tax Treatment in Non-Conforming States

The presence of non-conforming rules or the absence of a state income tax significantly impacts the state-level tax treatment for investors completing a 1031 exchange. In states without a state income tax, investors benefit from no state capital gains tax liability on the exchange. This can make these states attractive for both relinquished and replacement properties, reducing the overall tax burden. Federal capital gains taxes are still deferred under the 1031 exchange rules regardless of the state.

For states with clawback provisions, the deferral of state capital gains tax is not absolute. When the property acquired through the exchange is eventually sold in a taxable transaction, or if the exchange chain is otherwise broken, the deferred state tax liability may become due. This can occur years after the initial exchange, requiring careful record-keeping of the original deferred gain.

The calculation of state capital gains tax in these scenarios can differ from federal methods. For instance, the state may still consider the original basis of the relinquished property when determining the gain subject to its tax, even if the federal basis was adjusted for the exchange. Investors are required to track a separate state-specific basis and report the deferred gain annually or upon a future taxable event, as seen with California’s Form FTB 3840 or Oregon’s Form 24. Understanding these ongoing reporting requirements and potential future tax obligations is important for investors engaging in 1031 exchanges involving properties in states with clawback provisions.