Deferred Gain from an earlier 1031 exchange

12 replies
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Hi All,

My client has MANY K-1s; they buy and sell parts of real estate partnerships.

I just came upon a note in one that says INCLUDED IN YOUR PROPERTY DISTRIBUTION IS CALIFORNIA SOURCED DEFERRED GAIN FROM THE 2016 1031 EXCHANGE OF XXX APARTMENTS: $90,xxx.

I can't figure out how to report this deferred gain that now needs to be recognized. (In 2021, the current building was sold and the partnership was closed.)

How do I report this?

Thank you!

ProSeries Basic

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dascpa

Level 11

It's my understanding that California has a clawback provision whereas deferred gains from a 1031 are recognized when the replacement property is finally sold. It could be months to decades later.

hclistonAuthor

Level 5

Hi DASCPA,

I'm puzzled that you call it a clawback.

Isn't this the way 1031s always work?

My understanding is that, in all 1031s, you defer the gain at the time you make an exchange, but it's only deferred. Whenever the replacement property is sold, the unrecognized gain finally gets recognized. Is that not correct?

Thank you!

Heather

dascpa

Level 11

Copied from Legal1031 Exchange Services

California Claw Back

An IRC §1031 tax deferred exchange allows owners of real or personal property to defer the recognition of a capital gains tax they would have recognized when they sold their business or investment property. Capital Gains taxes are deferred indefinitely until such time the investor decides to cash out. Generally, the investor is only subject to state taxes in the state where the final property is sold however, some states take a different position whereby exposing the taxpayer to double taxation.

California regulations employ a “Claw back” provision that requires any gain in property value accrued in California at be subject to California state taxes, regardless of whether or not that property was exchanged for one in another state. At the time of a “cash-out” sale the taxpayer would be subject to the state taxes in which the property is being sold, as well as to California for the taxes applicable to the gain attributable while in California, thereby creating a partial double taxation scenario. Other states that have imposed a similar claw back rule for nonresidents who have exchanged in-state properties for out-of-state replacement properties are Massachusetts, Montana and Oregon.

The State of California Assembly passed legislation adding new sections to the California Revenue & Taxation code that require that 1031 Exchange investors that sell California Property and purchase Non-California Replacement Property to file an annual information return with the California Franchise Tax Board (FTB), reporting this Non-California property. The California State taxes that were previously deferred will be due if and when taxpayers sell their new non-California properties and elect to take their profits rather than continuing to defer taxes through another 1031 Exchange.

This information return must be filed in the year of the exchange and every year thereafter in which the gain is deferred. If taxpayers fail to file the annual return, the FTB may estimate taxes due and assess tax, interest and penalties. The new law shall apply to exchanges of property that occur in taxable years beginning on or after January 1, 2014. Although the new requirement to file an annual information return with the state of California is a burden, investors still will never have to pay the California taxes due under the California Claw-Back Provisions as long as they continue to 1031 Exchange from property to property.