What Are California’s 1031 Exchange Rules?
webmanager • April 11th, 2023
In our most recent YouTube video, we talk about the top 5 things that your real estate accountant should tell you about how to save money on taxes in real estate investing.
The #1 tip?
The 1031 Exchange. It’s one of the most powerful tax strategies in real estate. It allows you to defer your costly capital gain taxes for years and years into the future.
In today’s blog, we’re going to dive into what the 1031 Exchange Rules are in California so that you can start taking advantage of this powerful tax strategy in your real estate business.
Let’s dive in.
The IRS allows California investors to sell rental properties, business properties, and land that was purchased for investment purposes and defer all capital gains taxes via IRC Section 1031.
The 1031 Exchange is a tax deferral strategy used by many successful real estate investors. It allows you, as a real estate investor, to defer the federal and state income tax that would normally be incurred from selling real property, by using the proceeds of the sale to immediately purchase another ‘like-kind’ property.
And if you continue doing this over and over again until you die, chances are that you’ll pay ZERO taxes. Because your property gets stepped up in basis when you die, your heirs can turn around and sell it for the Fair Market Value (FMV), and owe ZERO taxes to Uncle Sam.
Of course, there are some rules that you need to follow, which we’ll cover in this blog.
But the cool thing is that you can use the tax money that you’d have paid the IRS otherwise to fund your next deal.
Like-kind property is a broad description of properties that are defined by the IRS as “the same nature or character, even if they differ in grade or quality.”
In terms of a 1031 Exchange, this means that any type of investment property can be exchanged for any other type of investment property, with the exception of any personal property (such as your primary residence or vacation home), which is not eligible for this type of trade.
Property types that are considered to be “Like-Kind” properties and are eligible for 1031 Exchange in California are:
The State of California has a few additional rules that apply on top of the standard federal 1031 exchange rules and regulations.
Qualified intermediaries (QIs) are required to maintain a fidelity bond of $1 million or more, or keep all exchange funds in an escrow or trust account.
If you are undertaking a reverse or forward exchange, you have 45 days from the date of closing of the replacement property to identify which of your properties is going to be sold.
From the original date that the property is sold, at the close of escrow, you have 180 days to complete your 1031 Exchange and close escrow on the new property.
Qualified Intermediaries must maintain an errors and omissions insurance policy of at least $250,000.
As mentioned above, any type of investment property can be exchanged for any other ‘like-minded’ investment property.
To have 100% of capital gains taxes deferred in a 1031 Exchange, the replacement property needs to have a fair market value that’s equal or greater than that of the relinquished property. Otherwise, any remaining balance after the purchase of the replacement property (also known as “the boot”) is subject to capital gains tax.
The name on the tax return and title of the relinquished property must match the name on the replacement property.
The only exception to this rule is that you can use a single-member LLC in lieu of your personal name to sell or purchase.
If you are considering trading into more than one property, you must follow either the 200% rule or the three-properties rule.
3 Properties Rule: You can identify one, two, or three properties and acquire any of them, or all three, as long as the purchase property is greater than or equal to the fair market value of the relinquished property.
The 200% Rule: If more than 3 properties are being considered, you can identify as many properties that you like as long as the total market value of the identified properties does not exceed 200% of the value of the relinquished property.
The 1031 Exchange is a powerful tax strategy that you don’t ever want to forgo in your real estate business.
However, the rules and regulations in California can make it tricky to comply with.
The best advice we can give you is to work with an experienced real estate accountant who knows the 1031 Exchange in California in and out.
If you don’t have a real estate accountant in California that you are happy with, or simply don’t have one yet, you can book a quick 15-minute call with one of our team members anytime.
We’ll be happy to help.
Stay tuned next week when we’ll release our 2023 Comprehensive Guide to 1031 Exchange that should answer even more questions such as filing requirements and various types of exchanges.
Until then!
Samy Basta brings you more than 20 years experience in tax, financial, and business consulting to his role as founder of Basta & Company. His focus is primarily strategic business planning, empowering clients to set priorities, focus energy and resources, and strengthen operations. In addition, Samy and his firm provide strategic counsel, and technical insight, on a wide range of needs, including tax saving strategies, tax return compliance, as well as choice of entity.
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