California, especially Silicon Valley, has long been regarded as an international hub for business. The Golden State’s economy is the largest in the U.S. and outranks all but a handful of foreign nations.
California also has some of the largest retail, office, and industrial real estate markets in the country. Opportunities abound for investors to swap investment properties through 1031 exchanges. This guide should help property owners better understand exchange requirements so they can effectively navigate drop and swap 1031 exchanges in California.
What is a 1031 Exchange?
A drop and swap 1031 exchange is a property swap that allows investors to defer any capital gains when they realize a profit from the sale of their original investment properties.
It’s the opposite of a straight sale, where those taxes are immediately due. Executing a 1031 exchange and rolling over the entirety of sale proceeds into a like-kind replacement property – dropping and swapping – allows you to defer capital and depreciation recapture taxes. It’s a process that can continue indefinitely as well. You can drop and swap your replacement property at a later date (a one-year hold time is generally considered the minimum requirement) and continue purchasing larger assets in an attempt to increase asset value and yield. When you die, you can bequeath any assets involved in 1031 exchanges to your heirs at a stepped-up basis to fair market value, which may eliminate those deferred tax liabilities.
How Does a Drop and Swap Work in California?
The State of California Franchise Tax Board generally adheres to rules and stipulations outlined in Internal Revenue Code Section 1031. Here’s an overview of the most pertinent aspects of that tax code:
- Exchanged properties have to be held as investments or used in trade or business. This stipulation excludes exchanges of vacation properties, second homes, and primary residences. However, if you rent these properties out for a minimum of two years, they may qualify for 1031 exchange treatment.
- Properties must be like-kind in nature, though that’s a broad definition since most real estate can be considered like-kind. Exchange properties don’t have to be the same asset class – you can swap a retail building for a medical office property, or a duplex for a triplex. The key is that assets are similar in nature and character.
- Exchange properties must be of equal or greater value in order to avoid creating taxable boot.
How to Execute a 1031 Drop and Swap Exchange in California
Here’s a quick guide to executing a 1031 exchange in California. It’s important to note that each individual investor's situation is different, so exchange requirements will vary depending on their property, cost basis, and investment strategy.
Step 1: Engage a qualified intermediary. QIs must facilitate all aspects of the 1031 exchange process. Investors may not take receipt of sale proceeds at any point during the exchange, or it will be disqualified.
Step 2: List and market your property. It’s important to line up potential replacement assets as soon as possible since you only have 45 days after close of sale to formally identify the replacement assets that will make up the second stage of your 1031 exchange.
Step 3: Close within 180 days. Once your original property closes escrow, you have 180 days to complete the exchange, or it will fail.
Putting it all Together
Drop and swap 1031 exchanges in California follow the same rules as any other state. However, investors must file a California Form 3840 to report like-kind exchanges executed on properties located within the Golden State, or if you recognize any gain or loss from an asset located in California that was part of a 1031 exchange.
Consult with a financial professional with experience in exchanges in the Golden State to seek more insight on effectively navigating drop and swap 1031 exchanges in California.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.