Because we handle 1031 exchanges in every state, we are frequently asked about the tax laws of individual states. Alexandra L. Hart, CESŪ and I always encourage exchangers to seek tax and legal advice from their own professionals, who are generally more knowledgeable about local laws and the exchangers’ particular circumstances. One of the most frequently asked questions involves non-resident tax withholding.
In many states, when an individual or entity that is not a resident of the state is selling real property, the state may impose a capital gains tax or other income tax. Because the seller is not a resident of the state, the state assumes that the seller will not file a tax return for that state. Once the property has been sold, the seller may have no further contacts within the state. If the seller does not voluntarily file a tax return and pay the tax, the state may never collect the tax.
As a measure to make sure all taxes are collected, most states have implemented a mechanism whereby the closing attorney or escrow company is required to withhold a portion of the sales proceeds and remit them to the state. In most cases, the amount required to be withheld is based on the gross selling price, not the actual amount of the gain. The reason for this technique is to make sure the taxes are collected, but without requiring an inquiry into the tax basis and other tax attributes of the seller. If too much is withheld, the seller can file a non-resident income tax return and claim a refund, if one is due.
Many states recognize 1031 exchanges and adopt the federal tax rules. As a result, exchangers who complete a valid 1031 exchange, with no boot, will owe no taxes to the state. If taxes are withheld and then later returned to the exchanger, then such amounts could be treated as boot, and subject the exchanger to tax; which is quite a bad outcome.
To ameliorate this Catch-22 scenario, states typically allow an exchanger to provide a statement or certificate at the closing which relieves the closing agent from the requirement to withhold any amounts for taxes. In Rhode Island, the form is known as Form 71.3. Other states have similar forms or processes. Some states require the seller to request the certificate days or weeks in advance of the closing.
So, if you are selling real estate located in a state in which you or the selling entity is not a resident, call us or check with your tax professional to determine whether non-resident withholding is required and, if it is, whether an exception exists for 1031 exchanges. Please click here to find some of the state non-resident withholding forms. Or click here for links to the various state websites.
Please contact us with any questions you may have. You can reach Alexandra L. Hart CESŪ at 877-395-1031 or by e-mail at AHart@AllStates1031.com.
