Another common misconception is the belief that because a transaction is tax free (really, tax deferred) for federal tax purposes the states will tag along and not subject the transaction to tax. While this certainly isn't true when we are addressing the possibility of transfer taxes or even sales tax for that matter (stay tuned), it may not even be true for state income tax purposes.
Put yourself in the shoes of the state taxing authorities. While a properly structured like-kind (1031) exchange can defer income taxes for years, it's technically only a deferral. The newly acquired property will inherit the lower basis of the old property. In theory, the federal government will eventually collect the tax on the ultimate sale in a straight transaction. State tax collectors may not be so lucky. What if the property being sold is in New York City and the replacement property is in Florida? As the law now stands, both New York State and New York City are out of luck and not entitled to any tax resulting from the appreciation on the New York property.
Several years ago, New York City tried to take the position that it was entitled to the tax without any changes to the law. The efforts of diligent practitioners made NYC quickly back down. More states have been enacting changes to their laws which attempt to lock in the portion of the gain on property that was owned in their state. This means that when the replacement property is sold, the state where the original property was located may be looking for a piece of the pie. Some states may go as far as not recognizing a 1031 transaction and will want the tax in the year of the exchange.
In some ways, it is easier for taxpayers where the state demands the tax when the exchange takes place. States that allow deferral, but look for a claw-back in the end, require continued filings to track any gain to which they may be entitled in the future.
If you have questions about how to best "align" federal and state tax treatment, please contact us.
Wayne Berkowitz, a tax partner and head of the State and Local Tax Group at Berdon LLP, advises on the unique requirements of governments and municipalities across the nation.