Summary
- A 1031 exchange is a tax-deferral strategy where you’re able to reinvest the profit from one property into the next without paying capital gains.
- To qualify for a 1031 exchange, you must follow strict rules and timelines and work with a qualified intermediary (QI).
- California requires you to file Form FTB 3840 each year so deferred capital gains can be tracked with the California Franchise Tax Board.
- If you need a professional to help with your 1031 exchange and avoid errors, Unbiased can connect you to financial advisors in your area.
What is a 1031 exchange?
A 1031 exchange is an IRS rule that allows you to defer capital gains taxes when you buy and sell property. Property owners must adhere to strict rules and timelines to qualify for a capital gains deferral when exchanging properties.
The benefit of deferring capital gains is enormous, so it’s beneficial to know what it looks like. Some of the rules and restrictions you need to know about include:
- Eligible properties: When you’re exchanging properties, it must meet the IRS’s definition of a “like-kind” investment property, which is similar in nature or character. It’s more flexible than you think; you don’t have to exchange one duplex for another duplex, for example, as long as the replacement property is held for investment or productive purposes for a business.
- Same taxpayer name: The name on the relinquished property must match the name on the replacement property.
- Equal or greater value: The value of the new property must be more than the property being relinquished. Additionally, all the profit from the sold property must be reinvested in the new property.
- Must use a qualified intermediary (QI): A qualified intermediary (QI) is a third party that facilitates the transaction by holding and reinvesting funds. It’s a requirement for a 1031 exchange.
- Follow Strict Timeline: To qualify for the 1031 exchange, you need to meet strict timelines. You have 45 days from the date the original property was sold to identify a new property for the exchange. You only have 180 days from the sale to close the transaction.
How does a 1031 exchange work in California?
California has some additional requirements for a 1031 exchange.
Every investor must file Form 8824 with the IRS, providing detailed information about the exchange, including the date of sale, price, and total proceeds.
California investors must also file Form 3840 with the California Franchise Tax Board each year to track the deferred capital gains.
What property is eligible for a 1031 exchange in California?
Not every property is eligible for a 1031 exchange. To identify appropriate properties, there are several rules you need to consider.
- Like-kind property: A like-kind property is defined by the IRS as a property that is of the same nature or character and is held for business or investment use. A personal residence or second home doesn’t qualify.
- Three property rule: You can identify up to three properties as long as you close on one.
- 95% rule: You must close on at least 95% of the total value of the properties identified.
- 200% rule: The value of the new property (or properties) cannot exceed 200% of the value of the property you’re replacing.
When you’re looking at potential replacement properties, it may not look like you’re replacing one property that is exactly like the one you’re selling. You can replace an older rental with raw land you intend to build on as long as you’re following the IRS guidelines outlined above.
How long do you have for a 1031 exchange?
Timelines are crucial for 1031 exchanges. If you’re unable to meet these deadlines, you’re required to pay capital gains.
There are two important numbers to remember:
- 45 days: You have 45 days from the sale of the original property to identify a “like kind” property.
- 180 days: You have 180 days from the sale of the first property to close on the newly-identified property.
There’s no flexibility with these deadlines, so be sure you’re able to identify and close on a new property within the allotted time period.
What are the pros and cons of a 1031 exchange?
A 1031 exchange has many benefits, but there are also some drawbacks to consider.
Pros
- Tax deferral: With a 1031 exchange, you defer paying capital gains taxes until a later date. You may be able to defer them indefinitely if you’re always invested.
- Retain profit: Not paying capital gains on every investment allows you to retain profit and reinvest in new properties.
- Diversify real estate holdings: An exchange allows you to change and diversify your real estate holdings without the need to pay capital gains.
- Upgrade to a new property: You can upgrade your property without paying capital gains on the original property.
- Can replace with multiple properties: IRS rules allow you to identify multiple properties to replace your relinquished property, which can be great for growing and diversifying your real estate investments.
Cons
- Limited time to find a new property: There’s a short time frame to identify (45 days) and close (180 days) on a new property.
- Flip properties don’t qualify: Investors who flip properties intend to buy, renovate, and sell as quickly as possible, which doesn’t meet the requirements for a 1031 exchange.
- Must reinvest all proceeds: You’re not able to keep any cash when you complete a 1031 exchange.
- Higher value requirement: The value of the new property must exceed that of the relinquished property.
- Complexity: You need to follow the rules with exactness, or you’ll pay capital gains.
Bottom line
There’s much to consider when you’re adjusting your real estate portfolio, especially when it comes to taxes. It’s helpful to have a professional in your corner.
Unbiased can connect you to a financial advisor who can help with any question that comes your way, whether it's 1031 exchanges, capital gains, or retirement portfolios.
A good financial advisor can help steer you in the right direction. Get connected to a financial advisor today.