I'm selling my replacement property from a previous 1031 exchange and know that some taxes will be do. What is a "clawback" provision?
Q: I used to own an investment property near Mt. Hood, Oregon, but sold it under a 1031 exchange for a rental condo near my retirement home in Hilton Head Island, SC. I am now selling that property and want to keep the cash instead of exchanging again. I know I may owe federal and state taxes. But I’ve also heard some reference to a “clawback provision”. What does this mean?
A: Utilizing a 1031 exchange is a great way to defer capital gains tax and can be repeated indefinitely. If you have the wherewithal to keep your equity working for you, your investment will continue to grow and benefit from the law of compounding. Some taxpayers, though, eventually need to cash out their equity and elect to pay the taxes. While most states match the federal income tax treatment where all capital gains taxes are deferred until the ultimate sale (state exceptions), there are some notable exceptions.
Unfortunately for you, Oregon is one. It has a “clawback” provision that triggers a tax on the old Oregon property when the new out-of-state replacement property is sold (HHI). Since the time you relinquished your Oregon property, you were required to file an annual report with the Oregon Department of Revenue so they could tax you when you sold the replacement property. California---another state with a similar clawback-requires even nonresident taxpayers to file a nonresident income tax return in the year the replacement property is sold.
California state regulations require that any appreciation in the value of a California property be subject to their state taxes, even if that property was exchanged for one in another state. This means that California property owners cannot escape California state taxes, even if they exchange their property for one in another state. Montana and Massachusetts also have clawback provisions for nonresidents who have exchanged in-state properties for out-of-state replacement properties.