1031 Exchange Rules in California 1031 Exchange Rules in California
Are you a real estate investor in California wondering how to use Section 1031 of the U.S. Tax Code to defer capital gains tax on the sale of investment property? The 1031 exchange rules in California are largely similar to those in the rest of the country, but there are some important differences specific to completing like-kind exchanges in the Golden State.
Below, we'll explore the ins and outs of what can qualify as a like-kind exchange in California, what the benefits are of using a 1031 exchange on California property, the 1031 exchange rules specific to California, and more. Without further ado, let's dig in.
What is a 1031 Exchange in California?
As mentioned above, California 1031 exchanges are largely similar to those in the rest of the country so let's first broadly define what a 1031 exchange (also known as a like-kind exchange or starker exchange) is. 1031 exchanges involve the sale of an investment property in exchange for a like-kind replacement property (or properties) of equal or greater value to defer capital gains tax that otherwise would have been subject to the property sold. Any real property can be exchanged provided it is held for "investment" or for the "productive use in a trade or business." In a 1031 exchange one property has to be exchanged for property of "like-kind" that will also be held for one of those investment purposes. This is often referred to as the "held for" rule.
To qualify for a 1031 exchange, California taxpayers must work with a Qualified Intermediary (like Leader1031) to structure the transaction as an exchange and not a standard sale. A QI must also be involved prior to closing of the sold property to create an exchange agreement with the taxpayer and obtain other documentation. To complete the exchange process, California real estate investors must identify any replacement property or properties in writing in a timely manner and their QI must hold the proceeds during the exchange period and apply them only toward the acquisition of replacement property.
What is Like-Kind Property in a California 1031 Exchange?
Let's dig in a little further -- what exactly does like-kind property mean when completing a California 1031 exchange? The IRS defines like-kind as properties "of the same nature or character, even if they differ in grade or quality." You're probably still wondering how similar a replacement property has to be to the property being sold to qualify. Whereas all “real property” may qualify, the term like-kind refers to how the real estate asset must be used or held for investment purposes. For example, commercial real estate can be exchanged for a single-family vacation rental property because they are both held for investment purposes.
In California, taxpayers can use 1031 exchanges to defer capital gains taxes on the sale of a variety of investment properties including multifamily homes, single-family homes, and commercial real estate. If you're wondering if a property transaction you're contemplating might qualify for a 1031 exchange to defer paying capital gains tax, be sure to reach out to a QI like Leader1031.
What Doesn't Qualify for a Like-Kind Exchange in California?
While "like-kind" may seem like a broad, all-encompassing term, there are limits and restrictions set out in Internal Revenue Code 1031 that property must adhere to in a 1031 exchange.
For instance, primary residences, second homes, flip properties, or property held in inventory for sale are just a few examples of property types that do not qualify as like-kind in California or other states. It's also important to note that due to recent changes to tax law, personal property such as artwork and boats are disallowed as like-kind property in a 1031 exchange at the federal level.
How to Identify Property for a 1031 Exchange in California
To avoid capital gains tax, California taxpayers must unambiguously identify a new property with an address or legal description in writing that is signed by the taxpayer initiating the exchange and send it to the QI within 45 days after the taxpayer’s property is sold.
There are three rules that California investors must follow when identifying like-kind real estate in a 1031 exchange:
- Three-Property Identification Rule: The investor may identify up to three replacement properties regardless of their fair market value. This does not mean that the taxpayer must close on all three properties. It's simply an opportunity to purchase one or more of those three properties through the exchange.
- The 200% Rule: The investor may identify any number of properties so long as the total fair market value of all the identified properties does not exceed 200% of the value of the relinquished property. Note: exceeding 200% of the value causes the third rule to apply.
- 95% Rule: If more than three replacement properties are identified and the sum of all identified properties exceeds 200% of the value of the relinquished property, then the taxpayer must acquire at least 95% of the total fair market value of all identified properties, otherwise, the entire exchange will fail.
By now, you're probably realizing that there many rules and regulations a 1031 exchange must adhere to in California. That's why it's important for taxpayers to surround themselves with a team of professionals to ensure all due diligence is done in identifying and exchanging properties.
What is the Section 1031 Exchange Timeline in California?
California taxpayers wondering how long a property exchange will take if it goes through the 1031 exchange process need to familiarize themselves with the 45-day deadline above, as well as the 180-day exchange deadline. Once an investor sells a property, the taxpayer has 45 days to identify a like-kind property (or properties) of equal or greater value plus an additional 135 days (if needed) to close on any identified property (or properties). This means that investors must acquire the new property and complete the exchange within 180 days (45+135=180) of closing on the relinquished property.
The 45-day identification period starts the day the sale of the property that is being relinquished closes. The taxpayer then has up to midnight of the 45th calendar day to unambiguously describe in writing to their QI, the property or properties they intend to purchase. They are not required to close on all properties identified and can revoke or revise their identification at any point prior to the 45-day deadline.
If a taxpayer does revoke their identification and does not have property identified before the lapse of the 45-day deadline, then the sale proceeds held by the QI will be transferred back to the taxpayer on day 46, triggering a failed exchange. This means the property exchange will be a taxable event and the exchanger will pay capital gains tax on the proceeds from the sale (as they would had they not initiated a 1031 exchange in the first place).
What is the California Claw-Back Provision?
Remember when we mentioned above that there were some aspects of 1031 exchange rules specific to California? Well, the California-Claw Back Provision is one of those rules. Basically, this provision stipulates that any capital gains accrued by California property are subject to California state tax. So, what does this mean for California 1031 exchanges?
Essentially, if California property is sold in a 1031 exchange and replaced with property in another state, and if the taxpayer sells the out-of-state property at a later time, then the taxpayer may be subject to paying capital gains taxes on that subsequent sale to both the state in which the replacement property is located as well as the state of California due to their “claw back” of the capital gains taxes previously deferred in the initial sale
Be sure to ask your QI, as well as your tax advisor, what impact the Claw-Back Provision could have on your 1031 exchange if you're in California.
How to Get Started With a 1031 Exchange in California
We said it above, but we'll say it again. The first step you should take if you're contemplating a 1031 exchange in California is to surround yourself with the appropriate team of professionals to guide you through the process, including a tax advisor, attorney, real estate agent, and Qualified Intermediary.
Finding the right QI to work with is crucial because it helps verify the security of your funds and provides your entire team with important knowledge and experience specific to 1031 exchanges.
As part of the process, your QI will work with your realtor, tax advisor, escrow professional, attorney and representatives for the property you are purchasing. With this in mind, you can see why it's important to choose a QI who will be able to lead your team through the exchange process.
Leader Bank's 1031 exchange subsidiary, Leader1031, serves as a QI for real estate investors seeking to sell and purchase property using the tax-deferred advantages of a 1031 exchange. These services provide greater integration and efficiencies for our commercial real estate clients, and Leader1031 is committed to providing the highest quality of service.
As soon as the property you are selling has gone into contract, you can set up a 1031 Exchange account with Leader1031. This 1031 Exchange account and certain documentation provided by your QI must be in place prior to the close of your relinquished property sale.
Leader1031 is ready to help ensure your transactions are in full compliance with IRS Code Section 1031. Contact Leader1031 today!.
It is imperative that you also consult with your own tax and legal counsel. Leader1031 is prohibited from providing tax and legal counsel as a qualified intermediary under the IRS Code Section 1031.
The content of this publication is provided as general information only and should not be taken as legal, investment or other professional advice. This content of this publication shall not be construed as a recommendation to participate in any particular trading, financial or investment strategy, and neither Leader Bank, NA nor Leader1031.com, LLC can provide legal or tax advice concerning the specific tax consequences of a given transaction. Any action that you take as a result of information or opinions provided in this publication is ultimately your responsibility. Consult your attorney, accountant, or tax professional before making any investment or financial decisions.
To ensure compliance with requirements under Treasury Department Circular 230, we inform you that the contents of this publication are not intended or written to be used, and may not be used, for the purpose of (i) avoiding U.S. federal tax penalties or (ii) promoting, marketing, or recommending to another party any matter addressed herein. Each taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax adviser.
