Often-times investors use a 1031 exchange to ‘move’ an investment property out of a high tax state. For instance, if an investor sells a highly appreciated property in, say New Jersey, they might be looking at paying top capital gains and NIIT taxes of 28.3% and an ADDITIONAL 10.75% in state taxes. As part of a comprehensive estate planning strategy, that investor might conduct a 1031 exchange and purchase a replacement property in a lower income tax state such as Florida. When the investor then sells THAT property, if they are in need of liquidity and not interested in deferring taxes they would likely only pay the federal portion of capital gains because Florida does not have state income tax.
Sound like a good deal? It can be. However, states are starting to catch on and want their share of their taxes. California is leading that charge with what is affectionately known as the “California Clawback”. As of January 2014, investors who own real estate in California and conduct an exchange to a property out of state are having their future transactions tracked through the requirement of an “additional information” tax return. If that property is sold and a 1031 exchange not conducted, even if that property is in a low or no income tax state, California is asking for their share of the tax revenues that would have been due at the time the California property was sold. And this is not a small share, because California has the HIGHEST top tax bracket of any state in union at a whopping 13.3%.
Obviously, investors are not going to be happy to pay that tax, so what can they do? The best way to avoid the tax man – whether it is in California or any other state, is to use the ‘defer, defer, defer… die’ method. Continue to conduct 1031 exchanges for the rest of your life. When you pass away, your heirs can inherit your property at a step up in cost basis. Their basis will be the value of the property the day they inherited the property. So when they sell that property they will have a very minimal tax burden. When coupled with a 1031 exchange this is the most powerful estate planning tool an investor has and its the only way to successfully avoid the dreaded California Clawback!
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