The 1031 tax-deferred exchange gets its name from Section 1031 of the Internal Revenue Code. It makes it possible for real estate investors to avoid paying capital gains temporarily.

Generally, the sale of property attracts capital gains tax, amounting to as much as 30 percent! So, if you sell a property valued at $300,000, the capital gains tax due can amount up to $90,000.

The 1031 tax-deferred exchange allows you to defer payment of such taxes.

Investors must carefully follow all the rules stipulated under Section 1031 of the Internal Revenue Service in order for an exchange to be successful. In theory, you could defer capital gains taxes again and again until your death and avoid them altogether.

If you’re planning to create wealth through real estate investments, the 1031 exchange mechanism is a wise tax and investment strategy.

Which Properties Qualify for 1031 Exchanges in California?

Not all types of property qualify for 1031 exchanges. A good example of a property that won’t qualify is a fix-and-flip property. That’s because a fix-and-flip property is bought solely for resale. A personal vacation/second home will usually not qualify either.

Properties that are eligible must meet certain conditions:

  • They must be business or investment properties.
  • They must not be under development for resale.
  • You must be deferring the capital gains by purchasing another “like-kind” property.

Speaking of like-kind, what exactly does it mean? Like-kind property means that they both have to be investment properties, and the transaction has to be a ‘transfer’, not just selling one property and then buying another.

The two properties don’t need to be the same type, though. The following are examples of possible exchanges:

  • A rental condo for an apartment building.
  • Raw land in exchange for a shopping center.
  • Raw land or farmland for developed real estate.
  • Residential property for commercial, industrial or retail property, or vice-versa.

It’s also worth noting that both properties don’t have to be in the same state.

What are the Time Limits for a Reverse 1031 Exchange in California?

Exchanges must meet certain timelines under the Internal Revenue Code. The time constraints are as follows.

  • 45 days – You have a maximum of 45 days to identify a replacement property once you’ve sold the original property. Once you’ve identified the property, you must notify your qualified intermediary in writing.
  • 180 days – Once you’ve selected a replacement propertyyou’ll have 180 days from the sale of the first property to close on the purchase of the next. An exception to this exists: If your tax return for the year of selling the original property is due before the 180 days, you’ll have to finish the exchange by the IRS tax return due date.

These deadlines are absolute and cannot be in any way changed or extended.

What Requirements Does a Replacement Property in California Need to Meet?

If you are purchasing one property, then, among other things, it must be like-kind. If you wish to buy multiple properties, the following are the guidelines you must follow.

  • Identify up to 3 properties of any value with the intention of buying at least one of them.
  • The 3 properties must have an aggregate value that doesn’t exceed 200% of the relinquished property’s market value. Or, the 3 properties you have identified must have an aggregate value that exceeds 200% of the relinquished property, but know that you must acquire 95% of the market value of all the 3 properties.

Who Can Qualify as an Intermediary in California?

In a 1031 exchange, you must wait until the exchange is complete to take control of cash or other proceeds. During this time, such proceeds must be held by a qualified intermediary.

You cannot nominate yourself or anyone else who’s worked for you in the last two years to be an intermediary.

So, how do you find one? It’s highly recommended that you use a qualified intermediary service that’s experienced in 1031 exchanges. You can ask your real estate agent or property management company for help.

What is ‘Boot’ in 1031 Exchanges?

Boot refers to money from a non-like-property that’s received in a 1031 exchange. Typically, the boot can be debt relief, cash, or personal property. While boot doesn’t disqualify an exchange, it merely introduces a taxable gain into the transaction.

Basically, your exchange will be partial rather than a fully deferred exchange. Consequently, the boot will be subject to capital gains tax. The following are examples of boot in 1031 exchanges:

  • Property that doesn’t qualify as like-kind. An example is personal property.
  • Debt relief on the property that has been relinquished.
  • Proceeds taken from the exchange in the form of a note.
  • Cash proceeds that the exchanger has received, for any reason, during the closing of the replacement property.
  • Cash proceeds taken from escrow by an exchanger before other funds are sent to the qualified intermediary.

When is a 1031 Exchange Beneficial?

If used correctly, a 1031 exchange can help an investor make use of money that would have otherwise be taxed for more valuable investments.

An example of how this works is illustrated below:

John owns an investment property in California that he bought for half a million dollars. The same property is now worth one million dollars and he’s thinking of selling it. If John sells it for cash, at a 20% combined tax rate, he’ll have to pay $200,000 in capital gains tax. This would then leave him $300,000 in profit.

John is also considering reinvesting the profits from his investment property in an office building. Using a 1031 exchange, trading the investment property for an office building means there will be no boot. Also, it means that John can defer the capital gains tax on the office building until he decides to sell it in the future.

For an exchange to be successful, you must strictly follow the guidelines set under the 1031 Internal Service Code.

For expert help, PURE Property Management can help. Get in touch with our qualified team to learn more about our services.