Understanding California’s Rules for 1031 Exchanges: What Real Estate Investors Need to Know
If you’re a real estate investor, you’ve likely heard of a 1031 exchange, also known as a “like-kind exchange.” This federal tax provision can be a game-changer when deferring taxes and growing your investment portfolio. But if you’re planning on selling property in California and purchasing a new property elsewhere, there are some specific rules you’ll need to be aware of. Many investors don’t realize that even after leaving California, the state keeps an eye on your capital gains — and it’s crucial to report this.
What Is a 1031 Exchange?
A 1031 exchange allows real estate investors to sell one investment property and buy another without paying taxes on the profit from the sale right away. Instead of handing over a portion of your earnings to the IRS immediately, you can roll the profit into a new property, giving you more money to reinvest. It’s a helpful tool for growing a real estate portfolio without being hit by a hefty tax bill after every sale.
Here are some basic rules to keep in mind when considering a 1031 exchange:
- This tax break is only applicable to real estate used for business or investment purposes. Personal homes or properties held for quick resale don’t qualify.
- You must identify a new property within 45 days of selling the old one and complete the exchange within 180 days. These tight deadlines are why it is advisable to involve a qualified intermediary.
- The replacement property must be of equal or greater value than the one you’re selling.
Why Use a Qualified Intermediary?
A qualified intermediary holds the proceeds from the sale of your property in escrow and ensures they go directly into the purchase of your replacement property. You can’t touch that money — doing so would disqualify the exchange. An intermediary acts as a safeguard to ensure the transaction follows IRS guidelines, reducing the risk of mistakes that could lead to a big, unexpected tax bill.
California’s Special Rules for 1031 Exchanges
While 1031 exchanges follow federal tax guidelines, California has its own rules, particularly if you’re leaving the state. If you exchange property in California for property in another state, California still wants to know about it. This requirement catches many investors off guard.
Suppose you sell property in California and exchange it for a like-kind property outside the state. In that case, California requires you to file an annual information return — Form FTB 3840, California Like-Kind Exchanges. This form tracks the deferred capital gain from your California property. Essentially, the state wants to ensure that when you eventually sell the new property, it gets its share of the taxes.
Many people fail to realize that you must file this form every year until you sell the replacement property, even if you’re no longer a California resident, and failing to file can result in costly penalties.
Take this for example:
Imagine that you’re a California resident who sells a rental property in Los Angeles and uses a 1031 exchange to buy a rental property in Tennessee. You successfully defer the capital gains taxes at the time of the sale, but California expects you to report that gain each year via Form 3840. Five years later, when you sell the Tennessee property, both the federal government and California will collect taxes on the gain, even though you no longer own property in California.
This ongoing reporting requirement surprises many investors. The idea is that even though you’ve left California, the gain on the original property was earned there, so the state expects its share when the deferred tax is finally due.
Final Thoughts
A 1031 exchange can be highly effective for real estate investors to defer taxes and continue growing their portfolios. But don’t overlook the state’s reporting rules if you’re selling property in California and buying elsewhere.
To avoid unexpected tax bills down the road, make sure you stay compliant by filing Form 3840 annually, even if you no longer live or invest in California. And, as always, it’s worth seeking professional guidance to ensure the process goes smoothly.
At Grimbleby Coleman Advisors and Accountants, we help you navigate the complexities associated with like-kind exchanges. Contact us today for tax insights and advice about your like-kind property investments.