Section 1031 Exchanges for Bay Area Rental Property Owners

A like-kind exchange can defer the tax on a rental property with decades of appreciation. The deadlines are unforgiving, and California keeps track of the deferred gain wherever you go.

Many Bay Area households own a rental property almost by accident: a condo kept after moving up, a parent's house inherited and leased, or a Sunnyvale starter home that became a rental. With median single-family prices in Santa Clara County near $1.92 million, a property bought fifteen years ago may carry a gain approaching seven figures, and the depreciation taken along the way adds to the tax on sale. Section 1031 of the tax code allows an owner to defer that tax by exchanging into other investment real estate, provided a strict set of rules is followed.

What qualifies

Since the 2017 tax law, Section 1031 applies only to exchanges of real property held for investment or productive use in a business. "Like-kind" is broad within real estate: a duplex can be exchanged for farmland, an office condo, or a fractional interest in a larger commercial property. What does not qualify is property used primarily for personal purposes. As an IRS fact sheet on like-kind exchanges puts it, a primary residence or a second home or vacation home does not qualify. A former residence that has been rented for a meaningful period can usually be exchanged, though the line between personal and investment use is a matter of facts and intent.

The timeline

In the typical deferred exchange, the owner sells the relinquished property and then acquires a replacement. The IRS fact sheet sets two deadlines that run from the sale closing: 45 days to identify potential replacement properties in writing, and 180 days to complete the purchase. These periods run concurrently, are measured in calendar days, and are not extended for a deal that falls through. Missing either one converts the transaction into an ordinary taxable sale.

Equally important, the seller may not touch the sale proceeds. The fact sheet notes that one way to avoid premature receipt of cash is to use a qualified intermediary to hold the funds until the exchange is complete. The intermediary is engaged before closing, holds the money, and disburses it to purchase the replacement. Choosing a reputable intermediary matters because the funds are outside the owner's control for up to six months.

Boot and full deferral

Deferral is complete only if the replacement property is of equal or greater value and all equity is reinvested. Any cash or debt relief received is "boot," and the IRS guidance states that gain must be recognized to the extent of other property and money received. An owner who sells a $1.5 million rental with a $400,000 mortgage and buys an $1.2 million replacement will generally recognize gain on the $300,000 shortfall. The exchange is reported on Form 8824 for the year of the sale.

California does not forget

Federal deferral does not end the state's interest. Under the rules for form FTB 3840, anyone who exchanges California property for out-of-state property must file the form for the year of the exchange and every subsequent year until the deferred gain is recognized. The source of the gain is fixed at the time of the original exchange, so when the replacement property in Texas or Idaho is eventually sold, the California-source portion of the gain is taxable by California even if the owner has long since become a nonresident. Failing to file can lead the FTB to assess tax on an estimated basis with penalties and interest.

Trade-offs

The appeal of an exchange is deferral, and potentially indefinite deferral if the owner holds the replacement property until death and heirs receive a stepped-up basis. The costs are real. Intermediary and transaction fees, the pressure of finding suitable property within 45 days in a competitive market, the risk of overpaying to meet a deadline, and continued exposure to a single asset class all weigh against the tax saved. Depreciation recapture and the 3.8% net investment income tax are deferred, not eliminated, and a later taxable sale may occur at higher rates. For an owner who simply wants out of being a landlord, the alternatives include a taxable sale spread by an installment note, a charitable remainder trust, or a delaware statutory trust interest that is itself exchange-eligible, each with its own limits and risks.

This article is educational only and is not tax, legal, or investment advice. Like-kind exchange rules are technical and unforgiving of errors, and readers should consult a qualified tax professional and a qualified intermediary before selling.

Important Disclosures

Important Disclosures: Propulsion Capital Management is an investment adviser registered with the State of California Department of Financial Protection and Innovation. Registration does not imply a certain level of skill or training. This article is provided for general informational and educational purposes only and does not constitute investment, tax, legal, or accounting advice, nor an offer or solicitation to buy or sell any security or to adopt any particular investment strategy. The information is believed to be accurate as of the date of publication but is subject to change without notice; tax laws and regulations change frequently and their application depends on individual facts and circumstances. Nothing herein should be relied upon as a substitute for personalized advice from a qualified professional. Investing involves risk, including the possible loss of principal, and past performance is no guarantee of future results. Diversification does not ensure a profit or protect against loss. Any examples are hypothetical, are for illustrative purposes only, and do not reflect the experience of any client. Links to third-party websites are provided for convenience; Propulsion Capital Management does not endorse, and is not responsible for, the content of third-party sites. Propulsion Capital Management does not provide tax or legal advice; please consult your tax adviser or attorney regarding your specific situation.