The California 1031 Exchange Rule

Real property exchanges that are called 1031 exchanges are basically tax-free in the U.S. The 1031 exchange rule is a power tax tool designed by the IRS to relieve the burden of paying the capital gains taxes for business and individuals who trade in investment properties.

The capital gains tax is primarily levied upon the sales of any capital asset which is calculated on the appreciation experienced during the period the tax payer has held to the property.

By qualifying for a 1031 exchange upon the sale of the asset, the capital gains taxes can be deferred indefinitely as per the IRS Section 1031 of the Tax Code.

Section 1031 of the IRS code

The basic eligibility requirements for a 1031 exchange is clearly defined and placed in Section 1031 of the IRS code. It states; No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

In this case, basically, we can describe the tax-payer as selling a property that he has used for business purposes or held as an investment. The owner can however defer his capital gains tax obligation by using the proceeds from the sale to acquire a similar property for the same purpose that is for business purposes or held as an investment. This is the like-kind rule of the 1031 exchange law.

The California Qualified Intermediate

Upon the close on the sale of a relinquished property, a 1031 exchange must be immediately initiated. The funds of the sale must be transferred to a qualified intermediary (QI), whose primary role is to hold the funds and assist in identifying the potential replacement properties.

Securities and bonds

In California, a Qualified Intermediary must maintain either bond in the amount of $1 million, a deposited amount of cash or securities of not less than $1 million, or a $1 million irrevocable letters of credit. The QI without this can deposit all 1031 exchange funds in a qualified escrow account or trust account. Damages sustained by anyone as a result of a facilitator’s violation of the California rules can make a claim against the bond, account or trust fund.

Moreover, a QI in California shall maintain errors and omissions insurance policy of not less than $250,000, or a cash deposit or securities in that amount, or letters of credit in an account allocated for this purpose.

Finally, a California QI shall act as the custodian for all the 1031 exchange funds they are handling and shall invest those funds according to prudent investor standard.

Like in most cases, the California Franchise Tax Board also requires a Qualified Intermediary, to withhold an amount equal to three and one-third percent of the sales price, as contingency if the exchange is not be completed.

How timelines really work

The owner has 45 days to identify the potential replacement property for a relinquished property. Additionally, he has 180 days from the close of the relinquished property to complete the purchase of the replacement property. These timelines are short and fast. Failure to meet the deadline will result in the taxpayer having to pay the capital gains tax.

A reverse 1031 Exchange can also be possible which essentially considers the same process and timetable but in reverse. The entire transaction in this case shall be handled by a Qualified Intermediary only. The Qualified Intermediary shall facilitate the transaction, take into possession of the titles and funds, and distribute them to the appropriate party at the appropriate time.

California 1031 Exchange Rules

The State of California has legislated additional rules to regulate Qualified Intermediaries. In general, the 1031 Exchange Rules in California states, that anyone who maintains an office in the state for the purpose of facilitating exchanges, advertises services as facilitator, in exchange for a fee is required to follow the California specific rules.

Clawback Provision

The State of California has also a clawback requirement for all California properties sold and entered into a 1031 exchange but replaced with an out of state replacement property. Per Section F of the California FTB Publication 1100 Irev 2007, a mandatory non-resident income tax return is required to be filed by non-California residents, in the year a replacement property is sold in a taxable nature. This is a California specific rule in addition to the 1031 exchange rule.