What is a 1031 Exchange?
1031 exchanges are a real estate tax break that allows commercial property sellers to exchange a business, trade, or investment property for another, like kind, property while deferring capital gains tax on the sale. Without this tax break, sellers must pay capital gains tax at the time of sale. California law does not require the 1031 exchange be in the same state, however, California does have a “claw back” provision that could ultimately lead to owing the deferred taxes. Understanding what 1031 exchanges are, how they work, and how California law differs from other states is crucial to ensuring you access every benefit of the tax break without incurring avoidable costs.
What is a 1031 Exchange?
By definition, a 1031 Exchange allows taxpayers to defer recognition of capital gains or losses on the exchange of real property kept for productive use in a business or trade investment, so long as the property is of “like kind.” (26 U.S.C.A. § 1031.) Productive use is defined broadly and generally includes any property held for profit. Like kind exchanges are rooted in the idea that one investor who exchanges a piece of property for another of “like kind,” is merely continuing an ongoing investment instead of cashing out one investment to obtain another. (Starker v. United States (9th Cir. 1979) 602 F.2d 1341, 1352.)
Eligibility for a 1031 Exchange is dependent on the exchange’s timeline and the Same Taxpayer Rule. To qualify, the replacement property must be identified within 45 days, and the exchange must be completed within 180 days of the relinquished property’s transfer. (26 U.S.C.A. § 1031.) The exchange must involve real property kept for productive use in a business, trade, or for investment, and cannot involve property held primarily for sale. (Ibid.) Under the Same Taxpayer Rule, the seller of the relinquished property must be the same individual buyer the replacement property. Failing to comply with either the statutory timeline or Same Taxpayer Rule disqualifies parties from receiving the tax break benefit.
1031 Exchanges may also require an exchange facilitator. Exchange facilitators are persons who facilitate the exchange of like kind property, for a fee, by acquiring the taxpayer’s relinquished property and then transferring the replacement property to the taxpayer as a qualified intermediary or as an exchange accommodation titleholder, qualified trustee or qualified escrow holder, as agreed. (26 U.S.C.A. § 5603(d).)
Special Rules for Relatives & Disregarded Entities
Special rules govern exchanges between related parties where the nonrecognition of gains or losses may be denied if the related party disposes of the property within two years of the initial exchange. (26 U.S.C.A. § 1031.) These special rules are designed to prevent taxpayers from using related parties to cash out investments while still receiving the benefits of the nonrecognition treatment.
Similarly, 1031 exchanges may occur between multiple entities. Generally, the Same Taxpayer Rule requires the seller of the relinquished property be the same as the buyer of the replacement property for the seller’s capital gains to transfer to their new property. When title is held by multiple entities this rule is violated, however, the IRS’ Regulations provide an exception called Disregarded Entities.
Disregarded Entities are entities that are separate from its owner(s) but chooses to be disregarded as an entity separate from its owner for tax purposes. (Regs. § 301.7701-3(a).) Under this exception, the disregarded entity’s activities are treated in the same way as a sole proprietorship, branch, or division of the owner. Business entities that are not corporations and have a single owner are generally always disregarded as a separate entity from its owner for federal tax purposes. (PLR 200131014.) In short, disregarded entities can exchange property between themselves as if they have a single owner.
The IRS’ Disregarded Entity exception even allows entities owned by a husband and wife as community property in California to be treated a single owner disregarded entity. In this setting, the IRS created a three-part test to determine whether entities qualify as disregarded entities when owned as community property by a husband and wife. The test requires that:
“(1) The business entity is wholly owned by a husband and wife as community property under the laws of a state, a foreign country, or a possession of the United States;
(2) No person other than one or both spouses would be considered an owner for federal tax purposes; and
(3) The business entity is not treated as a corporation under § 301.7701-2.” (Rev. Proc. 2002-69.)
Additionally, the test requires that the entity not be a corporation and that taxpayers did not design the entity as an association that would pay its own taxes. If the entity is either of these, they are disqualified from receiving the disregarded entity treatment and cannot participate in a 1031 exchange. (Cal. Code Regs., tit. 18, § 23038(b)-3.)
Delayed Exchanges
Delayed 1031 exchanges, commonly known as deferred exchanges, allow taxpayers to defer capital gains taxes on an investment property’s sale by directly reinvesting sale proceeds into a like kind property. Here, taxpayers must use qualified intermediaries to facilitate the exchange. The intermediary is responsible for holding the relinquished property’s sale proceeds and using them to purchase the like kind replacement property. (Silver State Broadcasting, LLC v. Beasley FM Acquisition (2015) 148 F.Supp.3d 1132, 1136.)
Successful delayed exchanges require:
- an exchange agreement with a qualified intermediary stipulating the qualified intermediary will receive and hold the sale proceeds until the replacement property can be purchased.
- The replacement property must be identified within 45 days of the relinquished property’s sale and title transfer. Additionally, the three rules of identification must be met.
- Three Property Rule: A maximum of three replacement properties may be identified without considering fair market value.
- Two-Hundred Percent Rule: The fair market value of all identified replacement properties cannot exceed 200% of the relinquished property’s aggregate fair market value.
- Nine-Five Percent Exception: The replacement properties may be identified without considering their combined market value if the acquired properties amount to at least 95% of all identified properties’ fair market value by the end of the exchange period.
- Lastly, the replacement property must be acquired within 180 days of the relinquished property’s transfer. (26 C.F.R. § 1.1031(k)-1.)
Taxpayers cannot take possession of the relinquished property’s sale proceeds at any time during the exchange. If the taxpayer takes possession of the sale proceeds or consideration at any time during the exchange, before receiving the like kind replacement property, the transaction is treated as a sale and the taxpayer recognizes gain or loss. (26 C.F.R. § 1.1031(k)-1.)
California Law’s “Claw Back” Provision
California law generally aligns with federal law governing 1031 exchanges; however, California law differs in one main way: the “clawback” provision. California’s claw back provision ensures California can collect taxes on gains from real property transactions, including 1031 exchanges with seller financing, when the transactions do not meet the requirements necessary for tax deferral. Under the provision, the deterred gain of failed 1031 exchanges is subject to California taxes, effectively “clawing back” the deferred tax benefit.
The provision provides that the intermediary or accommodator notify the Franchise Tax Board of any 1031 exchange that does not qualify for nonrecognition treatment for California income or franchise tax purposes. (Rev. & Tax Code, § 18662.) The intermediary must give notice within 10 days of the statutory periods’ expiration and remit any applicable withholding amounts. (Ibid.)
The provision additionally specifies that in case of an installment sale, the withholding requirements apply to each principal payment made under the installment sale agreement’s terms. (Ibid.) For seller-financed transactions, this means the withholding obligations are spread out across installment payments that allow the state to collect taxes on the gain as it is realized.
What is an Example?
“Shawn” and “Julie” co-own rental property in Southern California, they purchased together several years ago. Shawn and Julie originally bought the property for $500,000.00, and it is now worth $1,000,000.00, so they have a combined capital gain of $500,000.00.
After several years, Shawn and Julie’s business relationship deteriorates. As a result, Julie wants to reinvest her share of the property’s sale into another rental property, but Shawn wants to sell the property and take the proceeds in share to fund another venture, without Julie.
Julie suggests doing a 1031 exchange to defer taxes on their capital gains. Shawn is open to the exchange but will only agree if Julie agrees to sell the property so that he can cash out his portion of the profits immediately. Julie, however, wants to use the full $500,000.00 from her half of the sale proceeds to purchase another “like-kind” investment property in Southern California. Shawn’s desire to cash out his portion of the sale proceeds means his portion won’t qualify for the 1031 exchange.
Unable to agree, Shawn and Julie partition the property. As a result, Julie receives her portion of the sale proceeds to purchase a like kind replacement party in Southern California and benefits from the 1031 exchange by deferring taxes. Meanwhile, Shawn cashes out his portion of the sale proceeds and immediately faces the tax burden of his portion.
Conclusion
A 1031 exchange is a valuable strategy that allows investors to defer capital gains taxes on real estate transactions by reinvesting the proceeds into a like-kind property. If property ownership is a point of contention, partition may be a solution. The Underwood Law Firm has a team of experienced lawyers prepared to help you navigate your partition action efficiently and with care. We are here to help.