1031 Requirements, Benefits, & Process

Key Requirements and Process:

The properties exchanged must be "like-kind" and used for business or investment purposes.

A qualified intermediary (QI) is necessary to hold the sale proceeds and facilitate the exchange.

There is a 45-day window after selling to identify replacement properties.

The exchange must be completed within 180 days of the sale.

The replacement property must be of equal or greater value than the relinquished property.

The debt on the replacement property should be equal to or greater than the debt on the relinquished property.

Like-Kind property is a very broad term which means that both the original and replacement properties must be of the same character or nature, even if they differ in quality.

In other words,

you cannot exchange farming equipment for an apartment building because they are not the same asset. In terms of real estate, you can exchange almost any type of property, as long as it is not personal property.

California-Specific Rules:

CA has a "clawback" rule, meaning if you exchange a CA property for one in another state, the state still tracks the deferred gain and requires filing Form FTB 3840 annually until the replacement property is sold, even if you are no longer a resident. The tax is collected when the new property is eventually sold.

CA does not follow federal depreciation recapture rules and requires recapture of claimed depreciation as income on the state tax return.

Benefits of a 1031 Exchange:

Deferral of capital gains taxes, which can be substantial in California.

Ability to reinvest the full sale proceeds.

Potential for increased cash flow from rental income.

Important Considerations:

Strict adherence to the 45-day identification and 180-day exchange deadlines is critical.

Selecting a reputable QI is important for a compliant exchange.

Seeking advice from a tax advisor or real estate attorney is highly recommended to ensure compliance and determine if a 1031 exchange is suitable.

Examples of 1031 Exchange Strategies in CA:

Upgrading properties by selling a smaller one and acquiring a larger one.

Diversifying a portfolio by exchanging a commercial property for multiple smaller ones.

Note:

1031 exchanges are a complex tax deferral strategy with specific rules and limitations. Professional advice is essential for compliance and maximizing benefits.

How To Do A 1031 Exchange:

Traditionally, a 1031 exchange is where one property is literally swapped for another property of like-kind.

However, the likelihood that the property you want is owned by someone who wants your property is really, really unlikely.

This is why the vast majority of 1031 exchanges are delayed exchanges, also known as three-party exchanges.

In a delayed exchange, you need a middleman known as a Qualified Intermediary who holds onto the cash from the “sale” of your property and uses it to “buy” the replacement property for you.

In order to do a 1031 exchange successfully, it’s essential that you follow the following rules to a tee. If you fail to comply, you could be on the hook to pay capital gains tax, and nobody wants that.

1031 Exchange:

Deferral of Taxes:

when you sell a business or investment property that has appreciated in value, you would normally have to pay capital gains tax on the profit. A 1031 exchange allows you to postpone paying this tax by reinvesting the proceeds into a "like-kind" property.

Qualified Intermediary (QI):

in a delayed 1031 exchange (the most common type), you must use a qualified intermediary to hold the proceeds from the sale of your relinquished property. The QI ensures the transaction is compliant with IRS rules and helps facilitate the exchange. You cannot receive the cash yourself or the exchange will be disqualified.

Strict Timelines:

there are strict timelines that must be followed:

45-Day Rule:

you have 45 days from the date you sell your relinquished property to identify potential replacement properties in writing.

180-Day Rule:

you must complete the purchase of the replacement property no later than 180 days after the sale of the relinquished property, or the due date (including extensions) of your income tax return for the year of the sale, whichever is earlier.