Massachusetts State Tax Claw-Back Provisions for IRC §1031 Exchanges
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,” engage in a taxable sale by receiving non-like kind property (cash or other non-qualifying property). 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 potentially exposing the taxpayer to double taxation. The list of states that have these claw-back provisions, currently includes, California, Montana, Oregon, and Massachusetts.
Massachusetts claw-back provisions are found in state regulation MA 830 CMR 62.5A.1 “Non-Resident Income Tax” Section (3)(d) which requires that a taxpayer who exchanged MA real estate for real estate located outside of MA, to report and pay MA “source income” when they subsequently have a taxable sale (cash-out) of replacement property. The amount of gain that reflects appreciation of the MA property is “MA source income.” Exchangers of MA real estate are required to report the exchange and deferral of gain recognition on their state tax returns in the year of the exchange; however, MA currently does not have an annual filing requirement applicable to subsequent tax years (some states like CA have a strict annual filing after the Exchanger purchases replacement property in another state).
At the time of a taxable sale of replacement property, the investor could be subject to the state taxes in which the property is being sold, as well as MA “source income,” thereby creating a partial double taxation scenario. Exchangers selling MA real estate should review and analyze with their tax advisors: 1) their potential deferred Massachusetts liability; 2) their tax filing requirements; and 3) how this claw-back regulation may interplay with the tax laws of the state(s) in which they reside, and the state(s) in which the replacement property is located.
MA 830 CMR 62.5A.1(3)(d)1 provides in pertinent part:
(3) “Income Subject to the Massachusetts Income Tax”
(d) “Income from Ownership of Any Interest in Real or Tangible Personal Property.”
Example (3)(d)(1.6). Non-resident is a partner in a partnership that owns ten acres of land in Massachusetts. Non-resident sells his interest in the partnership. Non-resident is taxable on the gain from the sale.
a. Like-kind exchanges under Code section 1031. Massachusetts does not tax gain from the sale of real property that is deferred under the like-kind exchange provisions of Code section 1031. However, when the taxpayer subsequently disposes of the property acquired in such an exchange, the amount of the gain that reflects appreciation of Massachusetts real estate is Massachusetts source income.
Although the tracking the MA source income is a burden for Exchangers, investors still will never have to pay the deferred MA taxes due under the MA Claw-Back Provisions as long as they continue to 1031 Exchange from property to property. Please make sure to review your transaction with your own tax or legal advisor and review the most current version of any applicable state laws before moving forward with your transaction.
1Available on Mass.gov website at: https://www.mass.gov/regulations/830-CMR-625a1-non-resident-income-tax#-3-income-subject-to-massachusetts-income-tax , last visited 11/12/2020.
Legal 1031 Exchange Services, LLC does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of your exchange transaction. Property owners must consult their tax and/or legal advisors for this information. Our role is limited to serving as qualified intermediary to facilitate your exchange. © 2020 Legal 1031 Exchange Services, LLC. All rights reserved.