How to do a 1031 Exchange in California

The 1031 exchange is a federal provision of tax law that allows investors to defer the capital gains taxes they would otherwise owe when they sell an investment asset. The term “1031 exchange” refers to Section 1031 of the Internal Revenue Code and is also called a “like-kind” exchange of property. While earlier interpretations of the section allowed investors to defer capital gains taxes on a range of investment assets, Congress restricted the definition to investment real estate in 2017.

What are capital gains taxes?

Capital gains tax is levied on appreciation in value. For example, if you buy a rental property for $500,000 and sell it for $750,000, you have gained $250,000. The IRS and many states will tax that income. If you have owned the property for less than a year, the gain is "short-term," and the tax is at the same rate as ordinary income, like wages. However, if you hold the asset for more than a year, the gain is considered long-term, and the rate imposed is lower. Your overall income determines the rate assessed for either short or long-term gains. The highest bracket for short-term gains is 37 percent, but the highest rate for long-term capital gains is 20 percent. That difference has a substantial impact when paying taxes on the increase.

Most states also impose a capital gains tax, with the rate ranging from two percent up to thirteen percent for California, which is the highest. Nine states, including Texas and Florida, do not impose a state-level capital gains tax for individuals. All states with capital gains taxes will defer the taxes due if the taxpayer completes a 1031 exchange.

What happens when I defer the state taxes in California?

With any 1031 exchange, the capital gains taxes due are deferred, not eliminated. If you defer taxes using a 1031 exchange and later sell the replacement property using a standard transaction, you will then owe the deferred taxes (plus depreciation recapture, if applicable.) However, you can continue to exchange assets using Section 1031 and delay the accumulated taxes. Ultimately, if you bequeath the last property in the chain to an heir, you can successfully eliminate the accrued taxes. That benefit occurs because the heir receives the property on a stepped-up basis.

As with the federal taxes, the states with capital gains levies will seek to recoup the deferred taxes if you sell the replacement asset later. Typically, they only pursue the taxes if the replacement property is in the same state as the original asset (the relinquished property).

However, California (and three other states) have clawback provisions allowing the state to pursue the deferred taxes if you later sell the replacement property in another state. To clarify, let’s consider a hypothetical scenario:

A California resident uses a 1031 exchange to sell property in California and replace it with property in Arizona. This tactic allows the investor to defer both federal and state capital gains taxes. Later, the California resident sells the Arizona property, not using a 1031 exchange.

Now the taxpayer will owe federal income taxes. Since California previously deferred the state capital gains tax, it will now seek to collect it, even though California can’t collect tax on any gain enjoyed by the Arizona property. California will require exchangers to file annual returns in California as long as they still own the replacement property to facilitate the collection of taxes it can claim.