Will the state withhold tax at closing even though I'm doing a 1031 exchange?

The hold-back exists because the state cannot count on seeing your return

Nonresident real estate withholding is a collection mechanism, not a separate tax. The state takes a slice at settlement from a seller whose only connection to it is the property now being sold, then credits the money against whatever the return eventually shows.

That framing is why the exchange exemption works the way it does. You are not arguing the tax away at closing; you are certifying, under penalty of perjury, that a nonrecognition provision applies, so there is nothing yet to collect against.

Hawaii puts the logic on the face of its certificate: withholding is not required where "by reason of a nonrecognition provision of the Internal Revenue Code ... the transferor/seller is not required to recognize any gain or loss with respect to the transfer," with a written summary of the law and facts supporting the claim.

California exempts the exchange, then puts the withholding duty on your QI

Form 593 line 10 covers a simultaneous or deferred like-kind exchange, and the instructions state that a deferred exchange "is exempt from withholding at the time of the initial transfer." The seller signs the perjury statement; on an exchange the buyer does not sign at all.

The exemption is not open-ended. "However, if the seller/transferor receives money or other property (in addition to property that is a part of the like-kind exchange) exceeding $1,500 from the sale, the QI must withhold," and the withholding is 3 1/3% of that boot.

Hypothetical. A $1,200,000 California sale where you keep $40,000 at the end of the exchange produces $1,333 of California withholding on the boot, not $40,000 of withholding and not 3 1/3% of the price. What counts as boot in the first place is set out on what boot is.

If the exchange collapses, the accommodator withholds on the whole price

California's instruction is explicit: "If the exchange does not take place or if the exchange does not qualify for nonrecognition treatment, the intermediary or accommodator must withhold 3 1/3% (.0333) of the sales price." On the $1,200,000 hypothetical that is $40,000 taken out of the funds before they come back to you.

The credit follows the year the money moved, not the year of the sale: "If withholding was done for a failed exchange or on boot in the year following the year the property was sold, the withholding is shown as a credit for the taxable year the withholding occurred." Electing out of installment reporting means calling the FTB to move the credit.

That timing sits alongside the federal straddle question on when the QI releases your money, and the two calendars do not always line up.

Hawaii hands the certificate to the buyer; New York hands it to the county clerk

Hawaii's Form N-289 is completed by the seller and "given to transferee/buyer," with the instruction that the seller "should NOT file Form N-289 with the Department of Taxation for approval." The buyer's withholding duty under HRS §235-68 is discharged by holding the signed certificate.

New York's Form IT-2663 is presented to the recording officer with the deed: "If you exchange real property for real property of a like kind and no gain or loss is recognized under IRC § 1031 ... mark an X in box 4B, give a brief summary of the exchange, and indicate that the transaction is an IRC § 1031 like-kind exchange."

New York also fixes the rate on the form itself, line 19: "New York State tax rate 10.90% (0.1090)," applied to the gain rather than to the price. Filing the form does not remove the duty to file a New York return for the year.

• California: Form 593 goes to the real estate escrow person or remitter before escrow closes, and the QI reports again at the end of the exchange.
• Hawaii: Form N-289 goes to the buyer, who is the withholding agent, and is never sent to the department for pre-approval.
• New York: Form IT-2663 goes to the recording officer with the deed, and a zero payment still requires the voucher to be completed.
• All three want the claim described in writing, not just a box ticked: Hawaii asks for a summary of the law and facts, New York for a brief summary of the exchange.

Withheld money is not exchange money, and the certificate is not optional paperwork

Anything held back is wired to a revenue department, so it never reaches the qualified intermediary and cannot be reinvested. Plan the replacement purchase on the funds the intermediary actually holds, a figure worth confirming with the QI in writing before you identify.

Signing the certificate loosely carries its own price. A seller who "for the purpose of avoiding the withholding requirements, knowingly executes a false certificate is liable for a penalty of $1,000 or 20% of the required withholding amount, whichever is greater" under California's rules.

These are three states out of many with settlement withholding, and the rate, the form and the deadline differ in each; check yours on the state page under 1031 exchange rules by state, and confirm the filing with your CPA or attorney.

• Tell the escrow or title company the sale is an exchange when you open escrow, not in the final week.
• Get the state certificate signed and delivered before the transaction closes or the deed records.
• Ask the QI, in writing, to compute boot withholding at the end of the exchange rather than at the sale.
• Keep a copy of every certificate with the closing file; the credit is claimed on a state return months later.

Where this fits in the sequence of opening an exchange

Withholding is decided by the same documents that make the exchange work at all, so it belongs on the same checklist as the intermediary agreement and the assignment. What the QI needs to open your exchange covers the rest of that list, and does an exchange delay my closing covers what the QI is doing at the table.

Whether your state honours the deferral in the first place, and which ones keep a claim on the gain for decades, is the separate question taken up on state capital gains deferral.

We work as a 1031 exchange broker and coordinate with your qualified intermediary and escrow on the timing of these certificates; contact runs through the form on this site.