Why Cities Like New York Want A Bite Of Every 1031 Exchange
The 1031 exchange is a powerful tool for the real estate industry, allowing owners to roll over their stake in a property for an asset somewhere else without incurring a capital gain that could be taxed.
Not everyone is pleased with the arrangement, specifically the state and local tax collectors who are circumvented when deals jump state lines.
“Imagine you own a property in New York and you decide to exchange it for one in Miami,” said Wayne Berkowitz, state and local tax partner at Berdon LLP. “The way that New York State and NYC tax law is structured, neither the state nor the city will see a penny from any gain that was realized on that first property.”
An owner that bought a property in NYC for $1M 25 years ago might be able to sell that same property for $10M today, but if he did, he would incur a $9M capital gain. With a 1031 exchange, however, he could trade that asset for another that is also valued at $10M — subject to rules and regulations — while deferring any gain, and would receive an equivalent $1M basis in the new property.
The owner then could keep chaining these exchanges together, trading the Miami property away for another equally valued asset in another location.
Theoretically, Berkowitz said, a capital gain will eventually be realized when the newest property is sold outright rather than exchanged, and the IRS and the property’s home city and state would each have a piece in that eventual transaction. But as long as the owner keeps switching through exchanges, that gain continues being kicked down the road.
However, states and cities have found methods to return tax revenue to themselves when property owners head elsewhere.
Some states simply don’t follow the 1031 program. Pennsylvania, for instance, does not recognize 1031 exchanges at all, and forces owners to recognize their gain on any transaction. Other states, including California, have what is known as a clawback provision, which allows them to track the component of the gain that accrued in their state and receive taxes on it when the final property in the chain is sold outright.
A few years ago, Berkowitz said, NYC tried to rewrite the rules on the 1031 exchange. City officials attempted to implement an “accrual rule,” allowing the city to levy taxes on the gains as soon as a 1031 exchange occurred, rather than at the final outright sale.
“The city wanted owners to cough up the gain in NYC,” Berkowitz said. “There was serious uproar among industry professionals, and thanks to some diligent tax professionals, the city ended up backing off.”
He added that it would be entirely within the power of New York State to stop recognizing 1031 exchanges or to implement a clawback provision, but lawmakers have not introduced any legislation to either of those ends.
Although NYC does not have any restrictions on 1031 exchanges, it does have a levy that many real estate professionals overlook: transfer taxes.
In a properly structured 1031 exchange, an owner will not have to pay a “double tax,” that is, taxes upon exiting an old market and entering a new one, but they will still have to pay a single transfer tax. Even in so-called “reverse exchanges,” in which the property is held temporarily by an intermediate party, the owner will not have to pay double, but will still owe taxes on the one transaction.
“In our example of the New York and Miami properties, the state and city may very well lose out on any income tax,” Berkowitz said. “But for transfer taxes, there is no exemption, and the tax will need to be paid.”
He added that though it is a staple of the real estate industry, the 1031 exchange is still often misunderstood or misconstrued by the real estate industry. Consulting with a tax professional is the best way to ensure an exchange is structured properly and fulfills its tax obligations.
“1031 does not mean ‘tax-free,’” Berkowitz said.
This feature was produced by Bisnow Branded Content in collaboration with Berdon. Bisnow news staff was not involved in the production of this content.