Can you also defer state income taxes with a 1031 exchange?
Q: I live in Georgia, but have an investment property in another state. It’s under contract, and I am planning to do a 1031 exchange. While I know this will defer the federal tax due, will it also defer the state income tax?
A: Great question! In short, not all states are created equal. A 1031 exchange gets its name from section 1031 of the Internal Revenue Code. This tax-deferral strategy is part of the federal tax code.
There are some states with no state income tax-so there is no need to even report the exchange on the tax returns in those states. All other states mirror the federal tax code (caveat: some have claw-back provisions) except Pennsylvania. The Commonwealth of Pennsylvania does not recognize 1031 exchanges; so while you will defer the federal gain, you will have to pay the Pennsylvania state income tax. For Pennsylvania residents who sold property (located anywhere) or non-residents that sold property they owned in Pennsylvania, tax will be due. (For a ballpark, the 2010 tax rate for individuals was 3.07%.)
There used to be some states where you had to buy the replacement property in the same state in which the relinquished property was located. But in the last 10 years, this same-state requirement was eliminated in the remaining hold-outs of Georgia and Mississippi.
One final note. You must typically file a state return where the relinquished and replacement properties are located as well as in the state you reside.