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Real Estate Investment & Tax Transfers
The following should not be taken as tax advice. Anyone considering a 1031 Exchange should speak to a tax professional.
There are many reasons to sell an investment property. However, if that property has appreciated in value, you stand to pay a sizeable sum in tax based on the profit from the sale.
A 1031 exchange will allow you to defer paying tax on a property that you want to sell, freeing up more money for further investment.
A 1031 exchange might be right for you if you are planning to:
Invest in another property with better returns
Consolidate your assets so you have fewer properties to manage
Diversify your assets by investing in multiple properties of lesser value
Offset the impact of property depreciation on your asset's value
What is a 1031 Exchange in California?
A 1031 exchange is a method for deferring the payment of capital gains tax by exchanging one property for another. Because the properties are exchanged, rather than bought and sold in the traditional sense, no capital gains tax is required for the transaction. Tax is only required once the newly acquired property (or properties) is sold.
The exchange is subject to strict conditions but allows for multiple properties to be exchanged, to either consolidate or diversify assets. Exchanged properties must be investment properties, and similar to each other in kind. For example, multiple-residence income properties, like an apartment building, can be exchanged for another apartment building, even if they are different in grade and quality.
1031 exchanges require professional assistance. For example, a Qualified Intermediary (QI) is required to take control of the funds that are used to "buy" and "sell" the exchanged properties. The QI is an independent actor in the transaction, taking hold of the funds between the two parties in the exchange.
What are the Rules on a 1031 Exchange?
A 1031 exchange is subject to strict rules and regulations:
Properties must be exchanged rather than bought or sold.
The exchanged properties must be commercial or investment properties (not for personal use).
The exchanged properties must be similar in kind.
These cover the basic conditions of a 1031 exchange. The complete process and regulations are very complex, requiring assistance from specialized professionals.
Does California Recognize 1031 Exchanges?
1031 exchanges can be conducted both in and out of California. However, there are some additional state regulations that must be adhered to by Qualified Intermediaries.
Property Depreciation and 1031 Exchanges
A property depreciates by slowly losing its value over time due to general wear and tear. When the property is sold, an estimate of depreciation is used to calculate the amount of profit from the sale. The greater the estimated depreciation, the greater the potential calculated profit, and so the capital gains tax on the property will be higher.
1031 exchanges can be a way to exchange one property for another (or some combination of properties) with equal value, effectively "resetting" the depreciation on the invested assets. This can lower the capital gains tax that needs to be paid when the final property is sold.
1031 Exchange versus Opportunity Zone Program
Introduced in 2017, the Opportunity Zone program allows investors to defer some capital gains taxes by investing realized gains in a Qualified Opportunity Fund (QOF) which is then used to invest in Qualified Opportunity Zones (QOZ). There are currently more than 8,700 QOZs in the U.S., identified as areas neglected by traditional investment and requiring revitalization.
The Opportunity Zone program can be used to defer taxes on capital gains from any type of asset. However, the Opportunity Zone program has a number of limitations:
Investments cannot be made directly. They must be made through a Qualified Opportunity Fund.
Investments must be made in a Qualified Opportunity Zone.
Investments must result in significant improvements to acquired assets.
Tax deferments expire by December 31, 2026
In contrast, tax deferments from 1031 Exchanges can be extended indefinitely.
While both options allow an investor to defer capital gains tax, their precise differences can have significant effects further down the road. As such, it is important to consult an expert when choosing the right vehicle for capital gains tax deferment in California. California has some specific rules applying to 1031 exchanges which should be considered thoroughly.
Rules for 1031 Exchanges in California
Properties may be exchanged across state lines.
Qualified Intermediaries are subject to California-specific rules regarding where and how much funds are held to facilitate the exchange.
These include provisions for extra funds set aside to cover costs associated with errors, omissions, or incomplete sales.
Non-residents are required to file an income tax return for sold properties acquired in an exchange for a California property.
California law also allows different like-kind conditions for single filers making less than $250K.
The 1031 Exchange Timeline - How A Real Estate Agent Can Help You
The rules governing 1031 Exchanges state that replacement properties must be identified within 45 days of the initial property being given up and that the replacement must be secured within 180 days.
That's why it's important to have an experienced real estate agent on your side - someone who can help you find the perfect property (or properties) of the same or equal value to exchange. Jacqueline Thompson is an expert in Southern California luxury real estate, with extensive knowledge and reach in the local investment market. Contact her today for advice or assistance.
This information is not tax advice and anyone considering a 1031 Exchange should speak to a tax professional. Please refer to State and Internal Revenue Service for updated tax laws and policy changes.
Based on information from California Regional Multiple Listing Service, Inc. as of January 20th, 2021 at 1:51pm CST. This information is for your personal, non-commercial use and may not be used for any purpose other than to identify prospective properties you may be interested in purchasing. Display of MLS data is usually deemed reliable but is NOT guaranteed accurate by the MLS. Buyers are responsible for verifying the accuracy of all information and should investigate the data themselves or retain appropriate professionals. Information from sources other than the Listing Agent may have been included in the MLS data. Unless otherwise specified in writing, Broker/Agent has not and will not verify any information obtained from other sources. The Broker/Agent providing the information contained herein may or may not have been the Listing and/or Selling Agent.