How does a 1031 exchange work?
You sell real property held for investment or business use and buy other real property held the same way. The IRS sets two clocks from the sale: 45 days to identify the replacement property in writing and 180 days to receive it. Your own home doesn't qualify, and you report the exchange on Form 8824.
Since 2018 only real property qualifies, per the IRS (opens in a new tab). Most exchanges use a qualified intermediary to hold the sale proceeds, because taking the money yourself can end the exchange. Talk to a tax adviser before you list. The rules on what you hold, and for how long, are theirs to weigh.
What does California add?
California adds two things to a 1031 exchange: state withholding at sale and, if you buy out of state, annual reporting. A 1031 exchange can be an exemption from withholding, claimed on Form 593. Buying outside California means filing Form 3840 each year until the deferred California gain is recognized.
- Withholding at sale: California generally requires withholding on a sale of California real property. A 1031 exchange can be an exemption, claimed on Form 593 (opens in a new tab). If you take cash out of the exchange, withholding can apply to that part.
- Buying out of state: if you exchange California property for property in another state, the FTB (opens in a new tab) asks you to file Form 3840 every year until the deferred California gain is recognized.
Does California's rent cap apply to the rental you buy?
Often, yes. The Tenant Protection Act limits yearly rent increases on many California rentals to 5% plus inflation, never more than 10%, and requires just cause to end many tenancies. Some properties are exempt, including newer buildings, a duplex where the owner lives in one unit, and some single-family homes.
The single-family exemption applies only if the owner isn't a REIT, a corporation, or an LLC with a corporate member, and only if tenants get the required written notice, per the Senate Judiciary Committee's analysis (opens in a new tab). Many cities, such as Los Angeles and San Francisco, have stricter local rent rules.
This matters for financing. An investment-property (DSCR) loan is qualified primarily on the property's cash flow, subject to underwriting, so the lender works from the rent the property can legally collect, not from a hoped-for increase.
More on this: Business & investment loans
