There are generally no differences between 1031 exchange rules in California and elsewhere in the country. 1031 exchanges are based on federal IRS policy: IRS Code Section 1031.In the event that you’re considering doing a 1031 exchange in California, there are a few things you should know.
First, let’s talk about why you might consider using a 1031 exchange to trade property you or your client own in California in the first place.
How does a 1031 exchange work and what are the benefits?
A 1031 exchange is also referred to as a like-kind exchange. The reason is that it involves exchanging two properties that are “like-kind”, which is to say that they are similar in some way.
How does a 1031 exchange work, then?
Capital gains tax can be deferred by selling and purchasing an investment property through a 1031 exchange.
Here’s how you can approach it:
Capital gains will eventually need to be paid, assuming you or your client sell said property someday and within a certain time period.
If you were able to trade one property for another as many times as you wanted without having to pay capital gains on that last non-exchange sale, would you do it?
With that kind of flexibility, what could you accomplish?
Your clients and you can benefit from a variety of benefits, not just deferred capital gains taxes.
You could, for instance:
- Invest in properties in more promising markets instead of one market
- Consider trading high-maintenance properties for lower-maintenance ones
- In certain markets, you may be able to exchange high-risk properties for lower-risk ones or vice versa.
Let’s take a closer look at California’s 1031 exchange rules now that we have clarified that.
1031 Exchange Rules in California
California 1031 exchange rules have some unique quirks.
There’s only one sticking point in exchanging out of state, whether you’re exchanging for:
Property outside of CA for another within CA, or
For property within CA for another outside CA
We’ll talk more about the CA claw-back provision later and why that is.
Before we do that, let’s go over what the 1031 exchange rules are for California.
To do a 1031 exchange in California:
- It must be a business or investment property
- Of equal or greater value
- And like-kind
- The buyer and seller of the two properties must be the same taxpayer
- And you must complete the exchange within the 1031 exchange timeline
To make sure these rules are crystal clear, let’s break them down a bit:
1. Investing in or operating a business is required
Business or investment property can only be exchanged through a 1031 exchange. Several changes to the federal tax code in 2017 eliminated the ability to perform a 1031 exchange with personal property. The California Franchise Tax Board doesn’t recognize these changes.
1031 exchanges of personal property are possible in some cases.
If that’s the case, you should speak with your tax professional to ensure you’re taking the right steps to avoid any issues in the future.
Capital gains tax will apply if a mistake is made during the exchange.
2. A value equal to or greater than both properties is required
The replacement property’s net market value cannot be lower than the value of the relinquished property in order to qualify for 100% tax deferment. You must not purchase an exchange property whose net market value is lower than the relinquished property you are selling in order to qualify for 100% tax deferment.
Here are a few examples.
The following example qualifies for 100% deferment:
Sold (relinquished) property: $1,250,000
Property exchanged (purchased): $1,400,000
Due to the lower value of the exchange property, this one does not qualify:
Property relinquished (sold): $1,250,000
Property exchanged (purchased): $1,200,000
Another thing to keep in mind: mortgages are included in this calculation, as well as net market value.
Compared with the relinquished property, the replacement property must have an equal or greater net market value as well as a mortgage.
Accordingly, based on the net market value, this exchange qualifies for 100% tax deferment:
Net market value of relinquished (sold) property: $1,250,000
Net market value of exchanged (purchased) property: $1,400,000
However, if this is the balance on the mortgage, it is invalid since the mortgage on the new property is less than the mortgage on the relinquished property:
Property mortgage relinquished (sold): $650,000
Mortgage on exchanged (bought) property: $515,000
If the replacement property is less valuable than the relinquished one, what should you do?
The “boot” or the difference between the relinquished property and the replacement property is the difference in value.
As a result, you will have to pay capital gains tax on the difference immediately upon closing.
The $50,000 difference would be subject to capital gains tax:
The value of the relinquished property (the one you’re selling) is $975,000.
The value of the replacement property (the one you are buying) is $925,000
Under the 1031 exchange policy, the remaining $925,000 will be tax-deferred.
3. A like-kind exchange must take place
In most cases, it is not as confusing and restrictive as it may seem.
According to the IRS, the like-kind property is “of the same nature or character, even if they differ in grade or quality.”
The two properties generally should be used in the same way (which can include a wide variety of purposes).
You don’t have to worry about even something as simple as the properties being commercial because it’s pretty flexible.
4. Both properties must be taxed by the same taxpayer
The rules for 1031 exchanges are fairly straightforward here.
There must be a direct connection between the seller of the relinquished property and the buyer of the replacement property according to this rule.
It is not possible for multiple parties to carry out a 1031 exchange in order to prevent a potential loophole of transferring property between them during the exchange.
5. Exchange must be completed within 1031 exchange timeline
California tax return 1031 exchange instructions
California state tax returns are pretty straightforward to file 1031 exchanges.
When you exchange California real estate for like-kind property, you must file the following forms:
- For properties outside of California, perform a 1031 exchange
- Under IRC 1031, gain or loss can be deferred
- The FTB 3840 must be filed during the exchange year.
Additionally, it must be filed every year thereafter until one of the following occurs:
- Deferred gains or losses are subject to California state taxes
- An out-of-state 1031 exchange involves exchanging a new property out of state with another out-of-state property
- A replacement property’s owner passes away
- A non-profit organization may receive the property or it may be donated
As a result, 1031 exchanges in California follow the same IRS policy as elsewhere in the country, allowing investors and business owners to defer capital gains taxes. In California, a 1031 exchange must follow several key rules. A property exchange requires that both properties have an equal or greater value, be of a similar kind, and be owned by the same taxpayer. The 1031 exchange must be completed within 180 days of the deadline.
