A 1031 exchange allows a real estate investor to sell a property, without having to pay federal tax on the profit, and buy another with the proceeds. Most states that impose income tax honor the effect of the 1031 exchange by relieving investors of their state tax liability as well. California is one of those states.
A 1031 exchange, so named for the Internal Revenue Code that defines the process, occurs when a property owner reinvests the sales proceeds from the sale of a rental property into the purchase of another rental property. The proceeds must be held by a qualified intermediary -- that is a person or firm unrelated to the property owner -- and specific time frames for the identification and purchase of the replacement property are met. Under a 1031 exchange, the profits made from the sale are not taxed until the replacement property is sold. A 1031 exchange can be done innumerable times, however. If the replacement property is itself sold in a 1031 exchange, and each subsequent sale is conducted via a 1031 exchange, tax is not deferred indefinitely.
Normally, according to the California State Franchise Tax Board, 3.333 percent of the sales price or 9.3 percent of the profit is withheld from an investor when selling real estate in California. The board provides an exception, however, for owners who can certify that the transfer is part of a 1031 exchange, as defined by the Internal Revenue Code, because sales associated with a 1031 exchange are not subject to tax in California.
In California, however, you are not taxed on the sale of a 1031 property, according to William Exeter, president of Exeter 1031 Exchange Services. But if you sell a property and use a 1031 exchange to purchase a property in another state, you must pay tax on that portion of tax associated with the California property when you sell the property in the other state.
2010 Proposed California Prohibition
In response to a dire budget situation, in 2010 the California Legislature considered removing the 1031 exemption from California tax regulations. AB 2640 originally included language making the sale of a property associated with a 1031 fully taxable. On its second reading, this language was removed from the bill, with the effect that 1031 exchanges are still honored under California tax law.
What Happens in Other States
Some states, like Texas, do not have any state income tax. In those states neither 1031 exchanges nor regular sales trigger a state tax. However, there may be exceptions to this rule. For instance, if a limited-liability company does a 1031 exchange in that state, a gross receipts tax will be due on the sale. In states that do impose an income tax, rules regarding a 1031 exchange vary. In Mississippi, Oregon, and Vermont, for instance, to defer taxes the property, both the sold and purchased properties must be located within the state. Pennsylvania is the only state that does not recognize a 1031 exchange at all.