1031 Exchange Rules in California: What Orange County Real Estate Investors Need to Know

What is a 1031 exchange and what rules do Californian investors need to be aware of? We’re covering this and more in our guide to 1031 exchanges in California.

June 7, 2024

Selling an underperforming investment property for a similarly priced property with more potential is a sound business move. But what happens when the time comes to pay taxes on the sale?

If you’re an investor in California, you might understandably be worried about the implications of capital gain taxes on your bottom line.

Enter the 1031 exchange. This federal rule helps California investors defer capital gains on selling qualified investment properties.

But what is a 1031 exchange? And what rules do Californian investors need to be aware of? We’re covering this and more in our guide to 1031 exchanges in California.

What is a 1031 Exchange?
The Benefits of a 1031 Exchange for Investment Property Owners
4 Types of Real Estate Exchanges
What Properties Qualify for a California 1031 Exchange?
How are the 1031 Exchange Rules Different in California?
What is the California Claw-Back Provision?
How to Complete a 1031 Exchange in Orange County
Need help managing your Orange County investment property?

What is a 1031 Exchange?

A 1031 exchange is an exchange that occurs when you sell an investment property to purchase another. A 1031 exchange is governed by Code Section 1031 of the Internal Revenue Code (IRC). Sometimes referred to as a like-kind exchange, 1031 exchanges allow you to change the form of your investment without paying capital gains taxes. Your investment will continue to grow tax-deferred.

The Benefits of a 1031 Exchange for Investment Property Owners

As mentioned above, the main benefit of a 1031 exchange is that it allows you to defer capital gains tax.

If you were to sell your investment property, you would be required to pay capital gains. With 1031 exchanges, you can trade your property for another as often as you like. But instead of paying capital gains every time, you only have to pay on your final non-exchange sale.

1031 exchanges also allow you to increase your cash flow. For example, if you exchange a property with a lower rent potential for one with a higher one, you can immediately increase your flow.

Capital gains taxes are counterintuitive to wealth accumulation in real estate. Using 1031 exchanges to acquire more profitable assets while deferring taxes, you can grow your investment portfolio without losing money to capital gains.

4 Types of Real Estate Exchanges

Four different types of real estate exchanges can qualify as a 1031 exchange:

Types of Real Estate Exchanges that Qualify as 1031 Exchanges

Simultaneous exchange
Delayed exchange
Reverse exchange
Construction or improvement exchange

Let’s look at each one in more detail.

1. Simultaneous Exchange

A simultaneous exchange occurs when the property you are selling and the one you are acquiring close on the same day. Simultaneous exchanges are less common because they present logistical challenges.

If you plan for a simultaneous exchange but both properties don’t close on the same day, you will be required to pay capital gains taxes. Imagine that one of the properties is delayed for even a short period. The exchange could be disqualified, and you would be responsible for paying the full capital gains taxes.

For this reason, investors often rely on a qualified intermediary to facilitate the exchange, streamline the process, and reduce the risk of railing the time requirement.

2. Delayed Exchange

The most common type of 101 exchange is the delayed exchange. A delayed exchange allows you to sell your investment property before you purchase another property, using the funds from your sale to purchase the new property.

Once you’ve sold your original property, you’ll have 45 days to identify potential replacement properties and 180 days to close on your new investment property.

3. Reverse Exchange

A reverse exchange is like a delayed exchange but reversed. Instead of selling and buying a new property, a reverse exchange involves purchasing a new property first and then selling your existing investment property.

To complete a reverse exchange, you’ll need a qualified intermediary to hold the new property after you’ve purchased it. Then, you’ll have 45 days to identify the property you’ll sell and 180 days total to complete the sale.

These exchanges typically occur as cash deals, so you must have the cash on hand, as most banks don’t offer reverse exchange loans.

4. Construction or Improvement Exchange

A construction or improvement exchange allows you to improve the property before the actual exchange happens. The property will be placed with a qualified intermediary for 180 days, and you’ll be free to use the exchange equity to make improvements.

To qualify for a 1031 exchange, you must use all exchange equity as a down payment or for improvements within 180 days. The taxpayer must receive the same property that was identified on day 45. By day 180, all improvements must be made, and the property needs to be at an equal or greater value.

What Properties Qualify for a California 1031 Exchange?

1031 exchanges apply to any property that is used in a trade, business, or investment. Any investment property can be exchanged for another investment property. A duplex can be exchanged for a single-family home. An office building can be exchanged for an apartment complex. Raw land can be exchanged for a strip mall. Any combination of properties can be exchanged if they are investment properties.

Your primary residence isn’t eligible for the 1031 exchange as it is not considered an investment property.

In California, you can use a 1031 exchange on the following property types:

Multi-family housing
Student housing
Single-family homes
Retail centers
Healthcare
Storage facilities
Oil and gas
Industrial warehouses
Agriculture and farmland
Healthcare
Delaware Statutory Trust (DST)

How are the 1031 Exchange Rules Different in California?

Because the federal code governs 1031 exchanges, they are similar across the country. However, the rules in California differ slightly.

The 1031 Exchange Rules In California

The property must be a business or investment property.
The property must be of equal or greater value.
The property must be like-kind.
The buyer and seller of both properties must be the same taxpayer.
The exchange must be completed within the 1031 exchange timeline.

Let’s dig into the five rules that apply to all 1031 exchanges happening in California.

1. The property must be a business or investment property

All 1031 exchanges can only happen with business or investment properties. The State of California Franchise Tax Board doesn’t recognize the recent federal tax code changes that made personal property ineligible for a 1031 exchange.

There are, in fact, some cases where personal property can be 1031 exchanged, but it’s essential to speak with a tax professional to ensure you’re proceeding correctly. A tax professional can help avoid costly mistakes that may result in you needing to pay the full capital gains tax after the sale.

2. The property must be of equal or greater value

For your exchange to qualify for 100% tax deferment, the net market value of the property you’re purchasing must be of equal or greater value to the property you’ve sold.

This also applies to mortgages—the balance on the mortgage on your new property must be equal to or higher than the balance on the mortgage on the property you sold.

Let’s look at an example that does qualify for the 1031 exchange:

Sold Property	Purchased Property
Cost: $1,500,000	Cost: $1,940,000
Mortgage: $900,000	Mortgage: $2,000,000
This exchange would qualify for 1031 exchange as the cost and mortgage are equal or higher on the purchased property.

Now, let’s break down an exchange that would not qualify:

Sold Property	Purchased Property
Cost: $1,500,000	Cost: $1,400,000
Mortgage: $1,005,000	Mortgage: $1,000,000
This exchange would not qualify for 1031 exchange as the cost and mortgage are lower on the purchased property.

If the value of the replacement or purchased property is less than the value of the sold property, you’ll be required to pay the “boot” or the difference in value between the two properties.

So, in the above example, you would need to pay a capital gain of $100,000, while the other $1,400,000 would be tax-deferred.

3. The property must be like-kind

This is often the rule where many people feel restricted from making a 1031 exchange. But in reality, this rule isn’t as restrictive as people believe.

According to the IRS, properties are generally like-kind regardless of grade or quality. As long as they are of “the same nature or character”—meaning they serve the same purpose—they are considered like-kind.

So, any residential investment property would be considered like-kind even if one was an apartment complex and the other was a single-family dwelling.

4. The buyer and seller of both properties must be the same taxpayer

From a tax perspective, this rule is pretty cut and dry—the person who relinquishes the property and buys the replacement property must be the same person.

Multiple parties cannot perform a 1031 exchange.

5. The exchange must be completed within the 1031 exchange timeline

To qualify as a 1031 exchange, an exchange must adhere to the timeline set out in Code Section 1031. 1031 exchanges must be completed within 180 days of the sale of the relinquished property.

You must also hire a qualified intermediary when you set up a contract with your broker or realtor.

Next, within 45 days, you need to select three “exchange candidates”—potential properties that can be your purchase property. The final property you purchase must be one of these three properties.

What is the California Claw-Back Provision?

A critical piece of 1031 exchanges in California is the Claw-Back Provision.

According to FTB Publication 1100 Irev 2007, section F, the California Claw-Back Provision states that capital gains accrued by California property are subject to California state tax.

What does this mean for you? If you sell a California property in a 1031 exchange and replace it with an out-of-state one, you must pay capital gains on the final sale. This may seem harmless, but you could pay capital gains twice.

California applies this rule even after you’ve exchanged the property. Let’s look at another example to see how this can play out.

You exchange your California property for another in Utah using a 1031 exchange. The California property was worth $200,000 when you purchased it but has now appreciated to $350,000.

Down the road, you sell the Utah property. The previous $350,000 is now appreciated to $500,000.

You won’t just be paying capital gains on the $200,000 on the Utah property. Because of the California Claw-Back Provision, you must pay California tax on the $150,000 gains from the original exchange.

How to Complete a 1031 Exchange in Orange County

Completing a 1031 exchange in Orange County is the same as completing a 1031 exchange in California. You need to take six crucial steps to successfully qualify for a 1031 exchange. Here are the steps you need to take:

Talk to a tax professional or attorney. Before you start a 1031 exchange, you should speak with a professional who can assess if this strategy aligns with your goals and financial situation. They can help you understand the potential tax implications, eligibility criteria, and more based on your situation.
Hire a qualified intermediary. An independent third party is required during the 1031 exchange process. Ensure you hire someone familiar with 1031 exchanges and with a good reputation in the industry, as they will need to help you navigate the complex rules and timelines.
Find your three replacement properties. Within 45 days of selling your property, you need to identify three potential replacement properties of equal or greater value than the property you sold.
Assess the mortgages. The mortgage on the new property must be equal to or greater than the previous mortgage you held on the relinquished property. You will only qualify for a 1031 exchange if the property has a mortgage of at least the same amount.
Sale and fund diversion. When your property is sold, the funds go directly to the qualified intermediary and stay in a temporary account while the replacement property is found.
Receive funds. Once you find a replacement property, the intermediary uses the funds held to purchase the property.

Need help managing your Orange County investment property?

Managing the responsibilities and repairs of your rental can take time and effort. At Good Life Property Management, we believe life should be enjoyed, not spent sweating the small stuff. That’s why we set out to make property management easy. We care about you, your property, and your tenant. And we do it all so you can Live the Good Life.

Schedule a call to speak with one of our Good Life experts.