State Withholding on Out of State Sellers, and How an Exchange Avoids It

Investors who own property in a state where they do not live often get an unwelcome surprise at closing. Escrow tells them that state law requires a portion of the sale price to be withheld and sent to the state tax authority.

For a seller doing a 1031 exchange, that withholding can take cash out of the exchange at the worst possible moment. Money sent to a state is money not available to buy replacement property. The good news is that most states with withholding rules provide an exemption or reduction for qualifying exchanges. The bad news is that it usually has to be claimed before or at closing.

Why do states withhold on nonresident sellers?

Because it is hard to collect tax from people who do not live in the state. A nonresident who sells property and leaves may never file a return there. Withholding at closing ensures the state collects at least an estimate of its tax.

Several states have such rules, including California, New York, New Jersey, Hawaii, Colorado, Georgia, Oregon and others. The rates, thresholds and forms vary widely.

How much can be withheld?

It depends on the state. California's standard withholding is 3 1/3 percent of the total sales price, or an alternative calculation based on gain. Other states use different percentages of price or of estimated gain.

On a 2 million dollar sale, 3 1/3 percent is about 66,700 dollars, which is significant cash to lose from an exchange.

Does a 1031 exchange avoid state withholding?

Usually, if the proper exemption is claimed. Most states recognise that a qualifying exchange defers the gain and provide a way to certify that withholding is not required, or that it should be reduced to cover any boot.

In California, for example, the seller completes a withholding certificate indicating the transaction is a like kind exchange. If the exchange later fails or produces boot, withholding may be required at that point, often from funds released by the intermediary.

Each state has its own form, timing and conditions. The escrow or closing agent usually handles the forms, but they need to know about the exchange in advance.

What happens if withholding is taken anyway?

If the exemption is not claimed in time, the withheld amount is sent to the state. You may be able to recover it later by filing a nonresident return showing that the gain was deferred, but that can take months. In the meantime, the cash is not available for your replacement purchase.

To keep the exchange whole, you would need to replace the withheld amount with your own funds. Otherwise, the shortfall could reduce your replacement purchase and create boot.

What about the state where the replacement is located?

Buying property in a different state does not usually trigger withholding at purchase. But when you eventually sell that property, the new state's rules apply. Some states, most notably California, also track gain from property exchanged out of the state and expect reporting and tax when the gain is later recognised.

Does entity ownership change things?

Sometimes. Some states apply different rules or exemptions for corporations, partnerships and trusts. A property held in a partnership may involve withholding on nonresident partners. Check how the state treats your ownership structure.

What should you do before closing?

• ›Tell your escrow or closing agent early that the sale is part of a 1031 exchange
• ›Ask which state withholding forms apply and who prepares them
• ›Complete the exemption or reduction certificate before closing
• ›Tell your Qualified Intermediary about any withholding requirements
• ›Keep copies of all state forms for your CPA

What if you are exchanging out of state entirely?

Moving capital from a high tax state into a state with no income tax is a common goal. It does not necessarily eliminate the original state's claim on the deferred gain. Understanding the rules of both states before closing prevents surprises years later.

What does a worked example look like?

A Nevada resident owns a rental in California and sells it for 1.5 million dollars as part of a 1031 exchange. Without an exemption, escrow would withhold 3 1/3 percent of the sale price, 50,000 dollars, and send it to California's Franchise Tax Board.

Because the seller completes the California withholding certificate claiming the like kind exchange exemption before closing, nothing is withheld. The full net proceeds go to the Qualified Intermediary, and the seller buys a replacement property in Nevada.

The seller must still file a California nonresident return for the year reporting the exchange, and, because the property was exchanged out of California, file California Form 3840 each year while the gain remains deferred. If the Nevada property is later sold in a taxable sale, California expects its share of the original deferred gain.

What if part of the exchange produces boot?

If the seller receives cash or other boot, the state may require withholding on that portion. In some states, the Qualified Intermediary or escrow agent must withhold when boot is paid out after the exchange. Plan any intentional cash out with the state rules in mind.

What to do first

If you are selling property in a state where you do not live, ask your closing agent this week whether that state requires withholding and what form claims the exchange exemption. Build that step into your closing checklist alongside engaging the intermediary.

Nothing here is tax, legal or investment advice. State withholding rules change and vary. Confirm your requirements with your CPA and closing agent.