1031 from CA to TX, how to do?

Question

Hi there,

My elderly father owns a home in an affluent part of Northern California. He purchased it in 1982, so it has a low basis (and tons of deferred maintenance). He'd like to fully retire and sell it and then to move to Texas. He'd like to buy a condo (to live in) + some commercial or multifamily with the proceeds.

He says that California real estate taxes will take a massive chunk out of his gains and won't recognize such a transaction (SFH to condo+commercial) as a valid 1031 exchange.

Anyone familiar with doing 1031 exchanges across states and types of real estate?

Dave Foster · Answer

@AP Horvath, As long as his property has been used for investment (not his primary residence) he can do a valid 1031 exchange.  Moving from SF to any other type of investment real estate is fine.  And crossing state lines is fine as well.  The California clawback refers to a requirement by the Franchise Tax Board that if you do a 1031 and move the property out of state you must continue reporting it to CA on an annual basis.  And if you ever sell without a 1031 you must then pay the portion of tax owed while it was in CA.  The only thing that would prevent your father from doing a 1031 is if that property is his primary residence.

He can also can indeed use the 1031 to purchase a condo he might like to live in as long as he uses it long enough to establish his intent to hold for investment.  So again, if the CA property is an investment property he could 1031 out of CA and into a number of other investment properties including a condo that he would continue to use as investment for a period of time and then he could convert it into his primary and move in.  There is an IRS safe harbor for this practice extrapolated from Rev Proc 2008-16.

If the property is his primary residence then as mentioned above he can take advantage of the primary residence exclusion.  But Im guessing the actual gain would be much more than the exclusion.  So an option to still mitigate those taxes would be to move out of that property for a year or so and turn it into an investment.  Then he can later sell it and still take out his primary residence exclusion tax free (perhaps using this tax free money to purchase his condo).  And he can defer the rest of the tax by doing a 1031 exchange into other investment property.

Either way there are some great options available.  Maybe just some patience needed.  The Clawback does not have to affect him other than some reporting requirements

Dave Foster · Answer

@AP Horvath, There is no statutory time period for a conversion from primary to investment.  It is all about what your intent is.  Your father needs to be able to demonstrate that his intent was to use that property as an investment property.  There is a safe harbor of sorts in Rev Proc 2008-16 that establishes 2 years as acceptable with some other criteria.  What is not clear is how much less than 2 years would be acceptable.  It all comes down to how you demonstrate your intent.  A lot of folks are comfortable with anything more than a year because that represents two tax years and two tax filings.  An unsolicited offer to purchase or something like an executed lease option are also powerful evidences.

Your father would not have to have purchased a new primary residence but he would have to have a new primary residence.  He could rent or stay with you.

Dave Foster · Answer

@AP Horvath there are a few creative solutions that come to mind given the location.

1. Lease it with an option to purchase at the end of the lease.  Your ideal tenant profile would be someone who doesn't mind not moving in for a while but would rather work on the property to fix it up and then complete the purchase by exercising the option.

2. There may be a hungry land lord in waiting who would lease the property so they could fix it up and sub lease it in a landlord arbitrage model.

3. A joint venture or lease option with a rehabber where you either lease it to them so they can have control and fix it up and then exercise their option.  Or you and they could get it fixed up and then put a renter in it.  And then later you sell to them or sell to a 3rd party and pay the JV partner a % of profit.

None of these are perfect solutions and each has a little different risk profile.  But they may kick start your thinking. . And they could each still allow you to complete a 1031.

Bill Exeter · Answer

Hi @AP Horvath,

The relinquished property and the replacement properties would have to be held for rental, investment or business use in order to qualify for 1031 Exchange treatment.  It sounds (I'm guessing here) like the property that he is selling is his primary residence, so it would not qualify for 1031 Exchange treatment and at least one of his replacement properties will be a condo that he will live in, which will also not qualify for 1031 Exchange treatment.

The sale of a primary residence will actually fall under Section 121 of the Internal Revenue Code or what we refer to as the 121 Exclusion.  He can exclude up to $250,000 in taxable gain if he is single or $500,000 in taxable gain if he is married.

Let me know if my assumptions are incorrect here and we can circle back.

AP Horvath · Answer

Thanks @Dave Foster -- how long would it have to be leased for such that it legally changes status from primary residence to an investment property? Does he have to show a new (owned by him) primary residence?

AP Horvath · Answer

Thanks @Dave Foster and @Bill Exeter. I appreciate your thoughtful replies. A bit more background:a) Yes, it is currently his primary residence. He's in his 80s. b) He is considering trying to convert it into a rental but as I mentioned, the house has a *ton* of deferred maintenance (inside and out), meaning that it is extremely unlikely he could actually rent it to a 3rd party (which is what he thinks he could do). c) Also, he's "house-rich" but "cash-poor". Any tactical suggestions on what he and I might do to minimize or obviate the tax burden vis-a-vis a 1031? We're open to creative ideas.Thanks in advance.

AP Horvath · Answer

I should add -- this is known as the "California Claw-back".

1031 from CA to TX, how to do?

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