State Tax Rules for 1031 Exchanges: Understanding Non-Conforming States
While 1031 Exchanges are recognized under federal tax law, not every state follows the same rules. Some states “conform” to federal 1031 treatment, meaning they allow investors to defer state-level capital gains taxes along with federal taxes. Others, known as non-conforming states, do not recognize 1031 Exchanges for state tax purposes — which can lead to unexpected tax bills even when your federal taxes are deferred.
Here’s what investors need to know about how 1031 Exchange rules vary by state, and what to watch out for when selling or reinvesting across state lines.
What Is a Non-Conforming State?
A non-conforming state is one that does not align its tax laws with federal 1031 Exchange rules.
At the federal level, Internal Revenue Code Section 1031 allows investors to defer capital gains taxes on the sale of business or investment property if the proceeds are reinvested in a like-kind property.
However, in non-conforming states, the state’s Department of Revenue may still treat the sale as a taxable event at the state level — even if the IRS allows deferral. This means investors could owe state income tax on gains, even while their federal taxes remain deferred.
Examples of Non-Conforming States
While state laws can change, some states that historically do not conform to federal 1031 Exchange treatment include:
Pennsylvania – Does not recognize 1031 Exchanges for state income tax purposes.
Massachusetts – Generally treats exchanges as taxable at the state level.
New Jersey – Does not allow deferral under Section 1031.
Montana – Historically taxed 1031 gains, though certain exceptions may apply.
Conversely, most other states, including California, New York, and Florida, conform to federal 1031 Exchange rules — though some impose additional reporting or tracking requirements.
Because laws can evolve, it’s essential to verify the current rules in any state where you plan to sell or acquire property.
Partial Conformity: States with Special Requirements
Some states partially conform — meaning they generally follow federal 1031 rules but apply additional restrictions, such as:
“Claw-back” provisions: Certain states (like California) allow deferral but require future tax payment if the replacement property is sold and the gain is recognized while the owner resides elsewhere.
Reporting obligations: Some states mandate the filing of annual forms to track deferred gains.
Apportionment rules: When properties span multiple states, state tax authorities may allocate gains based on where the original property was located.
In these cases, the 1031 Exchange remains valid federally, but compliance with state-specific tracking and reporting is critical to avoid penalties later.
Investing Across State Lines
When conducting a 1031 Exchange between states — for example, selling in a conforming state and purchasing in a non-conforming one — it’s important to consider both jurisdictions’ rules.
Example:
An investor sells a property in California and reinvests in Pennsylvania.
Federally, the exchange is tax-deferred.
California will track the deferred gain under its claw-back rule (meaning taxes are due if the investor later sells and no longer lives in California).
Pennsylvania, being non-conforming, may tax the gain immediately at the state level.
Without planning ahead, investors may face an unexpected state income tax liability despite a valid federal deferral.
Key Considerations for Investors
If you plan to complete a 1031 Exchange involving a non-conforming or partially conforming state:
Consult your tax professional early. They can help determine whether your exchange will trigger state-level taxes.
Plan for potential state taxes. Even if your federal taxes are deferred, state-level tax liability could reduce your reinvestment funds.
Stay compliant with reporting requirements. File any required forms to track deferred gains, especially if you move states.
Work with a Qualified Intermediary (QI) who understands both federal and state regulations and can coordinate with your CPA or attorney.
Why Understanding State Conformity Matters
State conformity can significantly impact your net proceeds and overall tax strategy. Two investors could execute identical 1031 Exchanges but end up with different after-tax results depending on the states involved.
Knowing the state rules ahead of time ensures that you:
Avoid surprise tax bills,
Maintain compliance with both state and federal authorities, and
Make informed decisions about where and how to reinvest your capital.
The Bottom Line
Not all states play by the same 1031 rules. While the IRS allows full tax deferral on qualifying exchanges, non-conforming states may still tax your gain at the state level.
Before initiating a 1031 Exchange, confirm whether your state conforms to federal rules — and always coordinate with your Qualified Intermediary and tax advisor to structure the exchange correctly.
Disclaimer
This article is for informational purposes only and is not intended as tax or legal advice. Investors should consult a Qualified Intermediary, CPA, or tax professional familiar with both federal and state 1031 Exchange laws before proceeding with an exchange.
