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1031 Exchange Considerations for non-resident taxpayers selling Maryland real estate

Non-resident taxpayers considering the sale or transfer of real estate located in Maryland have some additional considerations compared to taxpayers in other states. While approximately eighteen (18) states have state tax withholding provisions for real estate transactions, Maryland’s withholding process for non-resident taxpayers requires some advance planning, in particular, when transacting an IRC §1031 exchange.

Withholding rules and rates: Maryland has a withholding requirement applicable to a non-Maryland resident individual (8.0%) or entity (8.25%) selling Maryland real estate.ⁱ

Maryland, like several other states (including NJ, NY, CA) has a process where a taxpayer transacting a 1031 exchange (“Exchanger”) can obtain an exemption from the required state withholding. Exchangers selling Maryland real estate should be certain to take advantage of this process because even though some or all of the money withheld for state taxes could be refunded at a future date by the stateⁱⁱ, the consequence of the taxpayer receiving or constructively receiving these funds is the amount withheld will not be eligible for tax deferral at the federal level and will be reported as income on their tax return. The federal tax liability on a required withholding can be significant for large transactions because an 8% or 8.25% withholding rate would apply to the gain.

For example: For $2,000,000 of capital gain on a transaction, the withholding amount could be approximately $165,000 ($2M x 8.25%). For purposes of example, at the marginal federal tax rates of 23.8% (cap gains 20% and NIIT 3.8%), the potential tax liability for not including this gain in the exchange could be $39,270 for partnerships or even more if the taxpayer is taxed as a corporation. This issue is briefly mentioned in an excerpt from the Maryland Comptroller’s website – Q. & A. below.

Guidance from the state discusses how to calculate the “total payment” and reminds the taxpayer to consider debts and allowable expenses for the sale when determining their taxable proceeds. The guidance also states that the closing agent (i.e. title company) is responsible for ensuring the proper amount is withheld and paid. Taxpayers are encouraged to review any withholding calculations or forms prepared by the closing agent with their tax advisors.

Exchangers can receive a Full or Partial Certificate of Exemption (“MW506E”): If they properly file an application with the Comptroller at least twenty-one (21) days before the closing. The Comptroller will not guarantee that a Certificate can be issued if an application is received within twenty-one (21) days of closing. The below excerpt from the state website explains the exemption process as it relates to IRC 1031 Exchanges.

Q. The transfer of the property will qualify as a like-kind exchange under §1031 of the Internal Revenue Code. Withholding part of the proceeds of the sale and paying this amount to the Clerk or Department will have adverse tax consequences for federal income tax purposes. How can I avoid the withholding requirement on the like-kind exchange?

A. You may file Form MW506AE, Application for a Certificate of Full or Partial Exemption, with the Comptroller at least 21 days before the settlement date. This form recognizes like-kind exchanges under §1031 of the Internal Revenue Code and numerous other transactions that are totally or partially exempt from income tax. Provided sufficient information is submitted with the application, the Comptroller will issue a Certificate of Full or Partial Exemption (MW506E). This certificate must be presented to the person responsible for closing at the settlement and to the Clerk or Department when the deed is presented for recordation. This will result in no tax or a reduced amount of tax that is required to be paid to the Clerk or Department. If a reduced amount of tax is being paid, a completed Form MW506NRS (Copies A and B) must be provided to the Clerk or Department when the deed is presented for recordation.

QI’s role in obtaining the exemption: It’s crucial that the taxpayer communicate with their qualified intermediary (“QI”) well in advance of their potential closing on relinquished property. While the taxpayer and their advisors are responsible for filling out the form, a letter from the QI verifying the taxpayer’s intent to exchange must be included with Form MW506AE.

In addition, based on the below excerpt from the Instructions to Form MW506AE, the QI must also state the amount of any “boot” (non-like kind property or cash) anticipated to be received by the seller. The rules appear to consider that many times, the taxpayer’s decision to take some cash from closing may not be completely ironed out weeks in advance of the anticipated exchange.

Tax-Free Exchange for purposes of §1031 of the Internal Revenue Code. Required documentation in addition to that on page 1; letter signed by the qualified intermediary, or by the person authorized to sign on behalf of a business entity acting as the qualified intermediary, which states the name(s) of the transferor(s), the property description, that the individual or business will be acting as the qualified intermediary for the transferor(s) as part of a §1031 exchange of the property, whether there will be any boot, and if so, the amount of boot. The amount of any boot must be stated on the application as the taxable amount.

What if I receive my Certificate of Exemption after I close, and the closing agent held funds in escrow pending receipt of the Certificate?

Sometimes closing agents hold exchange funds in escrow contingent on the resolution of a particular item – in this case, receiving the Exemption Certificate from the state exempting all or part of the proceeds received. If the Exchanger intends on deferring gain recognition by including these funds in the exchange, they must take care that they do not receive or constructively receive these funds. In other words, if the escrow is released, they should be sent directly from the escrow to the QI. This can often be accomplished by leaving instructions for the closing agent or signing an escrow agreement.

Links and resources to Maryland Withholding forms and guidance:

Maryland 2022 Nonresident Withholding on Sales of Real Property Forms

Maryland Form MW506AE- Application for Certificate of Full or Partial Exemption

Maryland’s Withholding Requirements

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Disclaimer- This article is provided for information purposes only and exchangers should consult and rely on the advice of their tax advisors regarding any topics discussed above.

Legal 1031 does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of any transaction. Taxpayers must consult their tax and/or legal advisors for this information. Unless otherwise expressly indicated, any perceived federal tax advice contained in this article/communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.