What Are the 1031 Exchange Rules in California?

Posted Jun 22, 2022

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If you need information about 26 U.S. Code § 1031, also known as “Exchange of Real Property Held for Productive Use or Investment,” also known as the 1031 exchange or like-kind exchange, you can learn a great deal from blogs on our website. This is our mission—we help clients manage investment property wealth through the use of this exchange.

But section 1031 is part of the Internal Revenue Code, which is a federal statutory tax law. It outlines the required deadlines and the need for a Qualified Intermediary to facilitate the entire exchange.

But if you’re considering a 1031 exchange to defer paying capital gains taxes on a real estate sale, simply knowing the IRC’s regulations might not be enough. You might also need to understand state-specific requirements for a successful exchange. If your targeted properties have anything to do with the state of California, it’s a good idea to familiarize yourself with the regulations issued by the state’s Franchise Tax board, or FTB.

An Overview

So, what are the 1031 exchange rules in California? The first thing to know is that anything that is state-specific requires following the state rules. So, if your relinquished or replacement property is in California (even if you don’t live there), you must follow the state’s rules. Furthermore, if you have an office in California for the purpose of facilitating exchanges, or advertise yourself as a state accommodator, Qualified Intermediary, or facilitator, you’re also required to follow the California rules.

The Qualified Intermediary

Like the IRC requirements, a 1031 exchange generated with California property requires a Qualified Intermediary, also known as an accommodator. But a QI you engage in this situation needs to observe the following:

Bonding Requirements

A QI who oversees a California property exchange for a fee (or who does business in California) is required to maintain the following:

  • A bond of $1 million or more, or
  • A deposit of $1 million in cash, securities or irrevocable letters of credit, or 
  • A deposit all exchange funds in a trust account or qualified escrow account

This is a form of protection; if the QI violates any of the California 1031 exchange rules, you could make a claim against the bond, account, or trust.

Errors and Omissions Policy

It’s generally a good idea to find a QI that is insured for any errors or omissions. Mistakes can happen, and such policies can help mitigate losses resulting from the error. QIs operating in California are required to maintain an errors and omission policy of at least $250,000. Failing that, the Golden State accommodators must deposit cash, securities, or letters of credit in an account used for the same purpose. 

Custodian Role

While all QIs under Section 1031 are responsible for handling exchange funds, the California QIs have an additional role. Specifically, they’re required to act as a custodian for all exchange funds, which requires a higher level of responsibility. Furthermore, they are required to invest those funds based on a prudent investor standard, based on the California Probate Code. There is a great deal of information here, but the gist is that the QI could potentially have more of an active role in ensuring that the exchange is a beneficial one.

Withholding Obligations

Finally, the California FTB mandates that the QI (in most cases) withhold an amount equal to 33 1/3 % of the sales price of any California property. This is done as a contingency on the chance that the exchange isn’t completed. 

The FTB 3480

California exchanges must be reported on the California Like-Kind Exchanges FTB 3840 under the following situations:

  • One or more California real estate assets are exchanged for one or more real properties outside of California and/or
  • Any part of the California-generated realized gain (or loss) isn’t recognized

Additionally, the FTB 3480 needs to be filed in the year of the exchange and each year following the exchange until you sell the replacement property in a taxable sale (i.e., not another exchange). When the time comes to do this, you’re required to file a nonresident income tax return in the year in which your replacement property is sold (assuming you, yourself, don’t live in California).

Keep in mind that even if that replacement property is exchanged for another out-of-California property, you must continue filing that FTB 3840 until:

  • You report and pay tax to California on your deferred gain or loss
  • You donate the property to a non-profit organization
  • You die

There’s more. Because of the California Claw-Back Provision, when that replacement property is sold, you’ll still need to pay taxes on any capital gains involved with that sale, even if that asset is outside the state of California. 

We’ve mentioned before that the 1031 exchange is complex, encompassing adherence to deadlines and specific rules. States like California have their requirements as well. If you’re considering exchanging into or out of investment real estate in California, be sure to understand the requirements to avoid being saddled with a surprise tax bill.

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. There is no guarantee that the investment objectives of any particular program will be achieved. The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that they will be able to pay or maintain distributions, or that distributions will increase over time. Programs that depend on tenants for their revenue may suffer adverse consequences as a result of any financial difficulties, bankruptcy or insolvency of their tenants. All real estate investments have the potential to lose value during the life of the investment.  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 returns, and may outweigh tax benefits. Because they are private placements, TICs are illiquid securities. There is no secondary market for TIC investments. Moreover, the form of ownership may require unanimous consent to sell a TIC interest.

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