Before outlining the specific 1031 exchange rules in California, let’s first introduce the basic concept of a 1031 exchange. In a traditional sale of property, a seller is required to pay capital gains taxes on any gain realized in the sale. One way to avoid paying capital gains taxes is to defer payment by entering into a Section 1031 Exchange. As the name implies, a 1031 Exchange contemplates an “exchange” of like-kind property instead of a traditional sale. If the transaction qualifies, any realized gain is deferred until the replacement property is sold at a later date. One common misconception is that property sold in California must be replaced by property in California, this is not true. The “like-kind” requirement is very general and allows for an Exchangor to acquire property outside of California should they wish to do so.
The Internal Revenue Service Code sets forth the requirements that must be met in order for a transaction to benefit from 1031 Exchange treatment. In addition to the requirements found in the IRS Code, Qualified Intermediaries must follow additional rules legislated by the State of California for exchanges where the old or relinquished property or the property parked with the Exchange Accommodator Titleholder is located in California.
How does a 1031 exchange work in California? The 1031 exchange rules in California state in general, that anyone who facilitates an exchange for a fee, maintains an office in the state for the purpose of facilitating exchanges, or advertises services as a facilitator in the state, is required to follow the California specific rules.
A Qualified Intermediary operating in California must maintain a bond in the amount of $1 million, deposit an amount of cash or securities or irrevocable letters of credit in an amount not less than $1 million, or deposit all exchange funds in a qualified escrow account or trust account. Anyone who has sustained damages as a result of a facilitator’s violation of the California 1031 exchange rules may make a claim against the bond, account or trust.
In addition, a Qualified Intermediary operating in California must maintain an errors and omissions policy of not less than $250,000 or must deposit cash, securities, or letters of credit in an account designated for the same purpose. Finally, a Qualified Intermediary in California must act as a custodian for all exchange funds and must invest those funds pursuant to a prudent investor standard.
The California Franchise Tax Board also requires a Qualified Intermediary, in most cases, to withhold an amount equal to three and one-third percent of the sales price of any California property as contingency should the exchange not be completed.
Clawback Provision
California has a “clawback” requirement for California property sold in a 1031 exchange and replaced with an out of state replacement property per California FTB Publication 3840. Non-residents are required to file a nonresident income tax return in the year the replacement property is sold in a taxable disposition.
Interested in learning more about when a 1031 exchange makes sense? Click here to download a complimentary eBook on “Ten Reasons Why a 1031 Exchange Makes Sense”.
We strongly recommend conferring with your CPA prior to engaging in a 1031 exchange. It is valuable to have the support and insight of your CPA when making the decision whether or not to proceed with an exchange.