Rules for 1031 Exchanges in California
In this post, we’ll cover:
- Key advantages of 1031 exchanges in California
- Criteria for eligibility and practical examples
- Recent changes in 2023 regulations
- How 1031 exchanges work with a step-by-step example
- Critical time requirements: 45-day identification and 180-day exchange periods
- Associated fees and closing costs
Have you wondered if 1031 exchanges may be right for you?
How does a 1031 exchange differ from a traditional real estate transaction, and what are the primary benefits for investors?
How complicated are they?
How can leveraging 1031 exchanges to defer taxes provide long-term financial benefits?
Let’s dive in.
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Smart sellers leverage 1031 exchanges to defer capital gains tax and build wealth more efficiently.
There are plenty of reasons why you should consider a 1031 exchange, including wanting to diversify your investments, relocate or expand your business, acquire a property that yields higher returns, and more.
Here’s what you need to know about using 1031 exchanges in California and valuable insights on how to leverage it to your benefit.
What Is a 1031 Exchange in California?
A 1031 exchange is a way to save on taxes when selling property. It allows sellers of a business or property to swap it for another and defer paying taxes on the sale. Otherwise, you'd be required to pay the tax at the time of the sale.
What Meets the Criteria for a 1031 Exchange?
Exchanges must involve like-kind properties, according to the IRS, meaning properties that are "of the same nature or character, even if they differ in grade or quality." This doesn't mandate swapping, for instance, one warehouse for another; you could even exchange it for a shopping center.
The key requirement is that both properties in the exchange must be held for investment, business, or trade and used for the same purpose.
These Examples Illustrate The Eligibility Criteria for a 1031 Exchange:
- Swapping one shopping center for another qualifies.
- Exchanging an office building you've been leasing to businesses for an industrial building qualifies.
- Exchanging commercially used land for a warehouse building also qualifies.
Key Advantages of a 1031 Exchange Include:
- Tax Deferral for More Capital: By deferring taxes, you free up additional capital to invest in your replacement property.
- Deferred Depreciation Recapture Taxes: The deferral extends to depreciation recapture taxes, with a maximum tax rate of 25%, compared to a potential rate of up to 37% upon cashing out.
- Diversification Opportunities: You can trade one property for multiple properties in different markets across the US.
- Consolidation and Time Management: You can exchange multiple properties for one, reducing the time spent managing rentals.
- Enhanced Investment Returns: Exchange your property or portfolio for others with higher returns, lower volatility, or better cash flow for long-term gains.
- Estate Planning Benefits: Utilize 1031 exchanges in estate planning, as tax liabilities cease with death, relieving heirs from paying deferred capital gains tax.
How Does a 1031 Exchange Work?
A 1031 exchange is a federal regulation and works the same in California as in most other states. Here’s an example that illustrates how it works in practice:
Let’s say you purchased a property for $1,000,000 in 2010. Since then, it’s been appreciating and is now worth $2,000,000. Upon sale, your capital gain is $1,000,000 and you are required to pay tax on it.
To avoid that, you can do a 1031 exchange and invest the whole selling amount ($1,000,000) into another like-kind property allowing your investment to continue growing tax-deferred.
You can do this as many times as you want. You’ll only have to pay tax once — when you cash out many years later.
Recent changes to 1031 Exchange Rules
In 2023, the rules for 1031 exchanges in California are:
You must purchase a like-kind property
Your new property must be of equal or greater value (to fully defer tax)
You must invest all the money you made from the sale
The new property must stay under the same taxpayer’s name
You must meet two time requirements(detailed below)
What Are The Time Requirements For a 1031 Exchange?
In California, as in many other jurisdictions, the 1031 exchange period is characterized by specific deadlines, including a 45-day identification period and a 180-day exchange period.
This means that from the time of selling your property, you have 45 days to nominate the replacement properties and you will have a 180 days from closing to acquire the replacement property. To be safe, you can nominate three potential properties of any value, and then acquire one or more of the three within 180 days.
A 1031 exchange intermediary, or Qualified Intermediary, will hold the cash from your sale in escrow and use it to buy the replacement property for you. But there are two deadlines or time limits to fulfill:
You can also do it the other way around — buy the property you want, name the property you want to sell in 45 days and sell it within 180 days.
Are There 1031 Exchange Fees and Closing Costs?
There are quite a few fees and closing costs you’ll have to pay. Here’s the general overview of what the 1031 exchange costs can be (on average):
Total exchange fees: $600-$1,200
Qualified Intermediary fees: $750-$1,250
Qualified Intermediary fee per extra property in the exchange: $300-$400
Appraisal for purchase contract: Around $5,000
Inspection fee: $0.1/sqft
Prorate taxes: Up to 110% of the last known property tax bill
Recording fee: $200 to thousands
Title insurance: Starts at 1% of the property value
Loan acquisition fees for the new property: Varies
Escrow fee: 1-2% of the total property value
Transfer taxes: 1-3% of the total property value
Attorney fees: Depends on your attorney
Brokers commission: 4-8% of the total property value
Can I Get a 1031 Exchange Extension in California?
Typically, obtaining an extension for your 1031 exchange in California is not a straightforward process, and, in most cases, it is not permissible. The regulations governing 1031 exchanges, which facilitate the deferral of capital gains taxes when swapping one investment property for another, often come with stringent timelines that must be adhered to for the exchange to qualify.
What Is the Two-Year Rule for 1031 Exchanges?
The two-year rule for 1031 exchanges mandates that all parties involved in an exchange hold their properties for a minimum of two years, starting on the day the last property transfer in that trade happens. If not, the exchange may be disallowed.
This is not meant to be tax or legal advice, please consult your CPA and or Attorney to advise you on your options.
If you'd like to know more about a 1031 exchange and if it may be right for you, give us a call at 949-632-2600. Our team is here to answer your questions and ensure you make the most informed decisions for your financial future.