Maximize Returns: A Guide to 1031 Exchanges in California

By Edward E. Fernandez | July 8, 2024

California is known for bustling urban centers and coastal retreats. The state’s robust property landscape presents investors with opportunities for diversification and maximum returns, especially with the 1031 exchange in mind.

However, this tax-deferred exchange requires a deep understanding of the rules. Today, we’ll explore this further by examining the specifics of 1031 exchanges in California.

 

What is a 1031 Exchange?

When selling a property, the profit is typically subject to both federal and state taxes, which could amount to as much as 40% of taxable capital gains. Due to these high tax liabilities, reinvesting in another property becomes challenging without utilizing a 1031 exchange. 

Referring to Section 1031 of the Internal Revenue Code (IRC), a 1031 exchange can offer investment property owners a continuous cycle of real estate investment without the immediate tax burden.

This strategy can potentially provide additional capital for your next property investment, lead to substantial tax savings, and defer capital gains taxes indefinitely, even until death. In most cases, the property basis may be stepped up for heirs, effectively erasing the taxable gain.

 

Exploring Investment Opportunities in California

California’s real estate market presents many investment opportunities suitable for 1031 exchanges. To qualify for a 1031 exchange, the property must be held for productive use in a trade or business or for investment purposes. With this in mind, investors can diversify their portfolio or invest in the following property types:

Urban Residential Properties

San Francisco, Los Angeles, and San Diego are some of the fastest-growing cities (recording the highest housing price hikes in the country.)

Opportunities may exist for multifamily apartment buildings, single-family rentals, student housing, and other rental properties, including luxury residential investments, in urban centers like Los Angeles.

Commercial Real Estate

California’s commercial real estate sector serves as a cornerstone for numerous industries, including technology, media, finance, and international trade, fostering vibrant hubs for commerce and e-commerce across the state.

  • Office spaces in Silicon Valley catering to tech startups and established companies
  • Retail properties in high-traffic areas across Southern California
  • Industrial warehouses and storage facilities in Los Angeles and Long Beach

Vacation Rentals and Hospitality

California is a perennial tourist favorite thanks to its extensive coastline and national parks.

Vacation rentals in coastal communities, such as Orange County, Santa Barbara, or the San Francisco Bay Area, have the potential to generate high returns.

Diversification opportunities in the hospitality sector also exist. For example, wine-country areas such as Napa and Sonoma offer ideal conditions for the development and success of boutique hotels and resorts.

Agricultural Land

Investment in agriculture and farmland in the Central Valley can be attractive, especially for those considering a 1031 exchange for a vacant piece of land. You can diversify away from urban and commercial properties here. You can either lease to farmers or gain long-term capital appreciation as food production values increase.

Development Projects

California’s growth and development projects offer the potential for significant returns. Areas undergoing gentrification or expansion make for excellent opportunities for redevelopment.

 

1031 Exchanges in California: Rules and Regulations

Investors must follow the federal rules outlined by the U.S. Internal Revenue Code and be aware of California-specific rules and regulations.

State Tax and Out-of-State Replacement Properties

Some investors exchange their property from another state for one in California. These have the following implications:

  • Cash Flow: By using a 1031 exchange at the federal level, investors can potentially increase their cash flow from rental income. This strategy allows them to defer capital gains taxes, freeing up more funds for reinvestment or other financial objectives. However, it’s essential to verify the tax implications specific to California. It’s recommended to consult with a tax professional for the most up-to-date information regarding California’s tax policies related to 1031 exchanges. 
  • Federal Depreciation Recapture: Depreciation is the amount of “wear-and-tear” you can write off during the ownership of your property. The IRS expects you to repay that tax break upon the sale of your property. California differs from federal depreciation recapture regulations. In California, depreciation previously claimed on the property must be recaptured as income on your CA state tax return. A 1031 exchange in California allows you to defer both state and federal capital gains and depreciation recapture tax after the sale of your investment property.

As an example, if you’re considering exchanging an investment property in Nevada for one in California, you’ll likely aim to defer capital gains and depreciation recapture tax upon the sale of your Nevada property. This strategic exchange could potentially optimize your investment and tax outcomes while facilitating portfolio growth in a new market.

California Franchise Tax Board (FTB) Reporting Requirements

California taxpayers must annually report and submit Form 3840, known as California Like-Kind Exchanges, to the California Franchise Tax Board. Form 3840 tracks deferred taxable gain on a replacement property outside the state.

Failing to comply with annual tax reporting may result in penalties or additional taxes imposed by the state authorities.

Like-Kind Property Considerations

The existing federal definition of like-kind property is quite broad. In the California Like-Kind Exchanges (FTB 3840), reporting on like-kind exchanges should be done in both cases:

  • An exchange involving one or more California real properties for one or more properties situated outside California
  • The realized gain or loss derived from California sources is not acknowledged

Additionally, investors must exchange for a replacement property of equal or greater value, ensuring compliance with IRS regulations. This means you cannot exchange your property for one of lesser value. Furthermore, it’s essential to consider any applicable loan-to-value (LTV) requirements during the process.

Claw-Back Provision

If you exchange a California property for one outside, the state will recapture the deferred capital gains tax from the original sale.

Here’s how it works:

Say you decide to exchange your commercial real estate in California for one in Florida. After a few years, you may wish to sell the Florida property to finance your retirement.

The clawback provision in California differs from other states in its approach to taxing gains from property exchanges. For example, if you exchange real estate in Texas for one in Florida, you’ll be liable for capital gains tax in Florida, the end destination. 

However, in California, if any property involved in the exchange touches California, you may be liable for capital gains taxes, even if California is not the final destination of the property. California will claim taxes on the gain deferred from the initial exchange.

 

Key Factors to Consider for California 1031 Exchanges

The following rules and limitations at the federal level also apply in California:

Like-Kind Rule

The properties involved must meet the “like-kind” requirement. This requirement stipulates that properties involved in the exchange must be of a similar nature or character. The IRS provides guidelines on what qualifies as like-kind properties in real estate exchanges, and taxation and real estate professionals can help you navigate this rule. 

Additionally, the property must be held for investment purposes or utilized as a trade or business property. Personal properties and residences do not qualify.

Timing Constraints

Investors must follow the 1031 exchange timelines :

  • 45-Day Identification Period: Investors have a 45-day window to identify potential replacement properties. This window starts from the day the relinquished property is sold.
  • 180-Day Completion Window: The exchange process must be completed within 180 days from the sale of the relinquished property or the due date of the tax return for the year in which the relinquished property closed, including extensions—whichever comes earlier. This timeframe commences from the sale of the relinquished property to the acquisition of the replacement property.
  • Qualified Intermediaries: Throughout these designated periods, it’s crucial that the seller refrain from retaining sale proceeds. The IRS requires qualified intermediaries to invest in sales proceeds on an investor’s behalf. The investor can never touch the money.

Property Identification Rules

Property Identification Rules are crucial in 1031 exchanges, governing how investors select potential replacement properties. These rules ensure compliance and guide investors through the identification process. Here’s a breakdown:

  • Three Property Rule: Investors can designate up to three properties as potential replacements, irrespective of their combined value.
  • 200% Rule: Investors can identify more than three properties as potential replacements. However, the combined value of all properties cannot exceed 200% of the original property’s market value.
  • 95% Rule: If the total value of identified properties exceeds 200%, the investor must acquire 95% of the combined market value of identified properties.

Estate Planning

  • Step-up in Basis: If a taxpayer retains a replacement property until their death, the heirs are granted a step-up in basis. This could eliminate any capital gains tax obligations. California does not have any provisions on estate planning for 1031 exchanges.

 

The Importance of Consultation and Expert Guidance

Professionals can assist you in navigating the intricacies of 1031 exchanges in California. Tax advisors, financial advisors, and real estate professionals provide knowledge and expertise on the following:

  • Complex regulatory environment: Strict time limits, identification rules, like-kind property criteria
  • Local market insights: Local trends, property management, property values, California taxes, and investment opportunities
  • Tax implications: Crucial guidance on deferring capital gains taxes, tax cuts, California claw-back provision, planning for future exchanges
  • Due diligence: Property selection, financing options, legal advice, and risk assessments

 

Empower Your Investment Journey with 1031 Crowdfunding

Using 1031 exchanges can help investors leverage tax-deferred strategies for portfolio growth and diversification. Nonetheless, investors will need a deep local understanding of state-specific rules in California. They will find themselves in a better investment position working with experts.

We’ve supported numerous investors in devising tax deferral strategies tailored to their needs. 1031 Crowdfunding grants access to meticulously chosen investment options across diverse real estate sectors. Each opportunity undergoes rigorous evaluation by seasoned experts to uphold standards and minimize risks.

Additionally, we extend personalized assistance and advice throughout the exchange journey, aiding investors in making well-informed choices aligned with their financial objectives and risk thresholds.

Register for an investor account with 1031 Crowdfunding today to explore the potential to enhance your real estate portfolios through 1031 exchange investments. 

 


This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees, and other expenses. This literature must be accompanied by and read in conjunction with a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. 

As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results, forward-looking statements and projections are not guaranteed to achieve the results described, and your actual returns may vary significantly. 

Investments in private placements are illiquid in nature, and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice, and you should consult with your tax advisor, as individual tax situations will vary. Securities offered through Capulent, LLC, Member FINRA, SIPC.

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