Savvy 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, get a property that yields higher returns, and more.
Here, we’ll go over everything you need to know about this tax break and how you can use it to your advantage.
What Is a 1031 Exchange in California?
A 1031 exchange is a real estate selling tax break. It allows commercial property sellers to swap out a business or commercial property for another and defer capital gains tax on the sale. Otherwise, you’d have to pay that tax at the time of sale.
What Qualifies as a 1031 Exchange?
Until December 2017, some personal property exchanges, including franchise licenses and equipment, qualified as 1031 exchanges. But after the Tax Cuts and Jobs Act (TCJA) was passed, only real estate qualifies.
However, exchanges must be between like-kind properties, which the IRS defines as properties “of the same nature or character, even if they differ in grade or quality.”
This doesn’t mean that you need to trade one warehouse for another. You could even trade it for a shopping center, for example.
This just means that both properties involved in the exchange must be held for investment, business, or trade and be used for the same purpose. For example:
- Exchanging one shopping center for another qualifies
- Exchanging an office building you’ve been leasing to businesses for an industrial building qualifies.
- Exchanging land used for commercial purposes for a warehouse building also qualifies
1031 Exchange Benefits
Here are the main benefits of the 1031 exchange tax break:
- Deferring taxes frees up more capital for you to buy your replacement property.
- Depreciation recapture taxes will be deferred as well. When you cash out, you’ll be taxed a maximum of 25% which could otherwise be up to 37%.
- You can trade one property for multiple properties in different markets (within the US) to diversify your investments.
- You can also exchange multiple properties for one if you want to spend less time managing your rentals, for example.
- You can trade your property or portfolio of properties for other(s) with higher returns, lower volatility, or with better cash flow that generate greater returns over time.
- You can use 1031 exchanges to plan your estate. Tax liabilities end with death, meaning your heirs won’t have to pay your deferred capital gains tax.
Does California Recognize 1031 Exchanges?
Yes, California recognizes 1031 exchanges as long as all the properties are located in the USA.
Does a 1031 Exchange Have to Be in the Same State?
No, a 1031 exchange doesn’t have to be in the same state. As of January 1, 2023, all 50 states recognize 1031 exchanges.
But there are some state-specific regulations you need to be aware of. Most states simply follow the federal Internal Revenue Code Section 1031, but not all.
The best way to capitalize on the different regulations each state has is to hire a seasoned broker that knows the 1031 Section inside out.
Can You Do a 1031 Exchange from California to Another State?
Yes, you can do a 1031 exchange from California to another state. However, California has a “clawback” provision on state taxes.
Here’s an example to illustrate what this means: let’s say you exchanged your commercial rental building in California for a similar one in Arizona.
A few years later, you decide to sell your Arizona property to finance your retirement. You’ll owe capital gains tax on that sale at the federal level and in both Arizona and California — that’s what the “clawback” provision means.
Massachusetts, Montana, and Oregon have this provision as well.
How Does a 1031 Exchange Work in California?
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 $2,500,000. You decide it’s time to sell. Your capital gain is $1,500,000 and you must pay tax on it.
To avoid that, you do a 1031 exchange where you invest the whole selling amount ($2,500,000) into another like-kind property. This way, your investment will keep growing tax-deferred as you roll your profit over.
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.
What Are the 1031 Exchange Rules in California (2023)?
In 2023, the rules for 1031 exchange 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 the two deadlines (we’ll go over them in the following section)
1031 Exchange — All FAQs Answered
Finally, we’ll answer some questions you might still have about 1031 exchanges in California.
What’s The 1031 Exchange Timeline or Deadline?
Since it’s very unlikely that the person selling the property you want also wants to buy the one you’re selling, most exchanges are “delayed.”
This means that a Qualified Intermediary (QI) or a 1031 exchange 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 fulfil:
- You have 45 days to tell your QI (in writing) what property/ies you want to buy
- You must purchase the new property within 180 days
To clarify, the 45 days are included in the 180. You have up to 180 days to finalize the whole process from the day you sell your property.
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. The good news is that most are tax-deductible or at least not tax-liable.
Here’s the general overview of what the 1031 exchange costs can be (on average):
- Total exchange fees: $600-$1,200
- QI fees: $750-$1,250
- QI 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 county 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?
Usually, no, you can’t get an extension on your 1031 exchange in California.
But due to the severe storms last winter, some taxpayers who started the 1031 process between July 12, 2022 and January 8, 2023 may exceptionally get an extension.
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 will be disallowed.
Get Help from a Seasoned 1031 Exchange Broker in Los Angeles
The intricacies of the 1031 Section combined with the tight deadlines and difficulty in finding properties to swap out make it imperative that you choose the right broker to guide you through this process.
Alex Matevosian leverages his connections and years-long experience in the industrial and commercial real estate sector in California to help commercial property sellers — like you — find the perfect property.
If you’re looking for a seasoned 1031 exchange broker in California who’ll always look after your best interests, contact Alex today.
MIG Commercial Real Estate Services Inc. and Alex Matevosian do not provide legal, tax, or investment advice. Any published articles, blog posts, resources, or other related material located on this website are for information purposes only. Please seek the advice of an attorney, tax professional, and/or financial advisor for legal, tax, or financial advice.