A 1031 exchange lets an investor defer capital gains tax when selling real property held for investment or business use, by reinvesting the proceeds in like-kind replacement property under Internal Revenue Code section 1031. The deadlines are absolute and the structural rules are unforgiving: one missed date, one wire sent to the wrong account, one mismatch between the selling and buying entity, and the entire deferral collapses. Bay Legal, P.C. structures and documents 1031 exchanges for California investors and handles the transactional side of both closings.
Definition: A 1031 exchange is the deferral of capital gains tax on investment real property by reinvesting the sale proceeds into like-kind replacement property within set deadlines.
What is a 1031 exchange?
Section 1031 of the Internal Revenue Code allows a taxpayer to defer recognition of capital gain on the sale of real property held for investment or for productive use in a trade or business, provided the proceeds are reinvested in like-kind replacement property. The gain is deferred, not erased. It carries forward into the replacement property, reducing that property’s basis, and becomes taxable when the replacement property is eventually sold — unless that sale is itself structured as another exchange. Investors who chain exchanges together can build a portfolio over decades without paying capital gains tax at each step.
The Tax Cuts and Jobs Act of 2017 narrowed the section sharply. Before 2018, exchanges of personal property such as equipment, aircraft, and artwork could qualify. Now only real property does. As of 2026, like-kind exchange treatment for real property remains fully available under federal law, and California has not moved to restrict it independently.
What property qualifies, and what is excluded?
For real property the like-kind standard is broad. Under 26 C.F.R. section 1.1031(a)-1, almost any real property held for investment or business use can be exchanged for almost any other. An apartment building can be exchanged for raw land. A warehouse in Fresno can be exchanged for a strip mall in Nevada. Property type and location are not the limiting factors. Use is.
Two exclusions apply regardless of type:
- A primary residence. Both properties must be held for investment or business use, not personal use.
- Dealer property. Real property held primarily for sale in the ordinary course of business, such as a developer’s inventory, does not qualify. The IRS and the courts have scrutinized fix-and-flip investors who characterize inventory as investment holdings. The question turns on the taxpayer’s intent and actual use at the time of sale.
How do the 45-day and 180-day deadlines work?
This is where most failed exchanges fail. Under IRC section 1031(a)(3), the taxpayer must identify replacement property in writing within 45 days of transferring the relinquished property, and must close on the replacement property within 180 days of that transfer — or by the due date of that year’s federal return, whichever comes first. Both dates are absolute. The IRS grants no extensions outside narrowly defined federally declared disasters.
The 45-day identification must be in writing and delivered to the qualified intermediary or the seller of the replacement property. A verbal identification is not an identification. Under 26 C.F.R. section 1.1031(k)-1, three identification rules are available:
- Three-Property Rule. Identify up to three replacement properties, regardless of their combined value. Most investors use this one.
- 200% Rule. Identify any number of properties, so long as their combined fair market value stays at or under 200% of the relinquished property’s value.
- 95% Rule. Identify any number of properties, but close on at least 95% of their aggregate value.
One trap deserves separate mention because it catches investors every year. If the relinquished property closes in October, November, or December, the 180-day window runs past April 15 — but so does the federal return due date, and the statute measures against whichever date is earlier. An investor who files a return on April 15 without having closed will be treated as having ended the exchange period on that filing date, not on day 180. The fix is simple and must happen in advance: file a timely extension, which pushes the return due date past the full 180 days. Raise this with your CPA before the relinquished property closes, not after.
Why does the qualified intermediary requirement matter?
Under 26 C.F.R. section 1.1031(k)-1(g), the taxpayer cannot take actual or constructive receipt of exchange proceeds at any point in the exchange period. If sale proceeds are wired to the seller, or parked in an account the seller can reach, the exchange is disqualified and the full gain becomes taxable immediately. A qualified intermediary — a QI, or accommodator — is an independent party who holds the funds under a written exchange agreement, releases them to acquire the replacement property, and keeps the taxpayer’s hands off the money throughout.
The QI agreement must be in place before the relinquished property closes. It cannot be added afterward. A closely related requirement is the same-taxpayer rule: whoever sells the relinquished property must be whoever acquires the replacement property. Title held in different names will disqualify an exchange, and that includes shifts between spouses, or between an individual and their own LLC, when the structure was not planned in advance.
What extra rules does California add?
California conforms to the federal rules in most respects, then adds obligations that follow the deferred gain indefinitely.
Clawback. Under Revenue and Taxation Code section 18032, California keeps the right to tax gain that originated from the sale of California real property, even after the investor exchanges into out-of-state replacement property and even after the investor leaves the state. When that out-of-state replacement property is eventually sold, the Franchise Tax Board asserts its claim on the original California gain.
Annual FTB Form 3840. To track those deferred gains, the Franchise Tax Board requires Form 3840, California Like-Kind Exchanges, to be filed every tax year in which the gain remains unrecognized — continuing until the replacement property is sold. Missing a year invites penalties and complicates the eventual calculation. Investors diversifying out of California real estate should treat this as a standing annual obligation, not a one-time filing.
Related-party exchanges. Under IRC section 1031(f), an exchange with a related party — a sibling, spouse, ancestor, lineal descendant, or an entity in which the taxpayer holds more than 50% — requires both sides to hold their respective properties for two full years afterward. If either party sells inside that window, the deferred gain becomes taxable immediately, subject to narrow exceptions for death and involuntary conversion. The FTB scrutinizes these arrangements closely, and the two-year hold applies for California purposes as well.
Which type of exchange fits the transaction?
Three structures cover nearly every exchange.
| Delayed (Starker) | Reverse | Build-to-suit | |
|---|---|---|---|
| Sequence | Sell first, then buy | Buy first, then sell | Buy, then improve, then sell |
| When to use it | The default; matches how most deals naturally run | The replacement property is available now and will not wait | The replacement property is worth less than the relinquished property |
| Needs an EAT | No | Yes | Yes |
| Governing authority | IRC § 1031(a)(3); codified 1984 | Rev. Proc. 2000-37 safe harbor | Rev. Proc. 2000-37; improvement variant |
| Relative cost | Lowest | Higher | Highest |
The delayed exchange, named for the 1979 Ninth Circuit Starker decision that validated non-simultaneous exchanges before Congress codified them in 1984, covers the overwhelming majority of transactions. A reverse exchange inverts the order and requires an Exchange Accommodation Titleholder, a special-purpose entity that parks title while the exchange completes, within a 180-day window under Revenue Procedure 2000-37. A build-to-suit exchange, also called an improvement exchange, lets exchange funds pay for construction on the replacement property so its value can be brought up to match the relinquished property and defer the full gain. Both non-standard structures need an EAT and careful drafting.
The most common way to lose part of a deferral is boot: cash or non-like-kind property received in the exchange, including debt relief when the replacement property carries less mortgage than the relinquished one. Boot is taxable to the extent received. Taking a cash payment to settle a small price difference, rather than adjusting the purchase, can trigger tax on that amount.
How does a California 1031 exchange work, step by step?
- Confirm eligibility. Verify the relinquished property is investment or business-use real property, not a residence or dealer inventory, and surface any entity or title problems before anything is signed.
- Retain a qualified intermediary. Select a licensed, bonded QI and execute the exchange agreement before the relinquished property closes.
- Close the relinquished property. The QI receives the proceeds directly. Both clocks start on this transfer date.
- Identify replacement property within 45 days. Deliver a signed written notice to the QI before midnight on day 45, describing each property unambiguously.
- Run due diligence on the replacement property. Title review, inspections, financing, and purchase agreement negotiation, inside the remaining window.
- Close within 180 days. The QI releases funds to acquire the replacement property. If day 180 falls past the return due date, the extension from step one of your tax planning must already be filed.
- File the required forms. IRS Form 8824 with the federal return, and FTB Form 3840 with the California return annually if the replacement property sits outside California.
What Bay Legal does, and does not do, on an exchange
Scope matters on this page more than most, because 1031 work sits at the intersection of three professions. Bay Legal, P.C. advises on the legal structuring of the exchange, reviews QI agreements and exchange documentation, and handles the real estate transactional work on both closings: purchase agreements, due diligence, title review, and closing coordination.
Bay Legal does not serve as a qualified intermediary, does not give tax advice, and does not prepare tax returns or FTB and IRS filings. Those belong to the client’s QI and CPA. There is a specific legal reason for the first exclusion: under 26 C.F.R. section 1.1031(k)-1(g)(4), an attorney who has represented a taxpayer within the two years before an exchange is a disqualified person and cannot act as that taxpayer’s QI. Clients needing a QI are referred to licensed intermediary services.
Who handles 1031 exchanges at Bay Legal?
Exchange structuring and the transactional closings run through the firm’s real estate group. Robert Brian Ponziano, a senior attorney and licensed California realtor, leads real estate transactions. Clarence Olson handles real estate matters alongside him. Where an exchange produces a contract dispute or a claim against a counterparty, the matter moves to the litigation group under managing attorney Jayson R. Elliott.
Bay Legal, P.C. serves investors statewide from offices in Palo Alto and Los Angeles, and works alongside the client’s CPA and qualified intermediary rather than replacing them.
Frequently Asked Questions
What properties qualify for a 1031 exchange, and what is excluded?
Since the Tax Cuts and Jobs Act of 2017, only real property qualifies. Both the relinquished and the replacement property must be held for investment or for productive use in a trade or business. Primary residences are excluded, as is dealer property held primarily for sale in the ordinary course of business. Within those limits, the like-kind standard is broad: almost any qualifying real property can be exchanged for almost any other.
What happens if I miss the 45-day or 180-day deadline?
The exchange fails and the full gain becomes taxable in the year of sale. There is no cure period and no administrative extension, apart from federally declared disasters meeting specific IRS criteria. For a fourth-quarter exchange where day 180 falls past April 15, filing a tax return extension is essential, because the statute measures the period against whichever date arrives first.
What is the California clawback provision, and how does FTB Form 3840 work?
Under Revenue and Taxation Code section 18032, California retains the right to tax gain that originated from California real property even after the investor exchanges into out-of-state property and leaves the state. To track it, the Franchise Tax Board requires Form 3840 to be filed every year until the deferred gain is recognized. Missing a year can bring penalties and complicate the eventual calculation.
Can I do a 1031 exchange with a family member or related entity?
Yes, but under IRC section 1031(f) both parties must hold their respective properties for two full years after the exchange. Related parties include siblings, spouses, ancestors, lineal descendants, and entities in which the taxpayer holds more than 50%. If either side sells inside two years, the deferred gain becomes taxable immediately. The two-year hold applies for California purposes as well.
What is a reverse exchange, and when would I use one?
A reverse exchange acquires the replacement property before the relinquished property sells, which is useful when a desirable property is available now and will not wait. Under Revenue Procedure 2000-37 it must complete within 180 days of an Exchange Accommodation Titleholder taking title, and it requires a written Qualified Exchange Accommodation Agreement. Costs and structuring complexity are both higher than a delayed exchange.
Does Bay Legal serve as a qualified intermediary?
No. Bay Legal, P.C. provides legal counsel on structuring and documentation and handles the transactional closings, but does not act as a QI. Under 26 C.F.R. section 1.1031(k)-1(g)(4), an attorney who represented a taxpayer within the prior two years is a disqualified person for that taxpayer’s exchange. The firm can recommend licensed, bonded intermediaries and will review the QI’s exchange agreement.
What is boot, and how does it affect my tax bill?
Boot is any cash or non-like-kind property received in the exchange, including mortgage relief when the replacement property carries less debt. Boot is taxable to the extent received. To defer the full gain, acquire replacement property of equal or greater value and reinvest all proceeds. Even a small cash payment to settle a price difference creates a taxable event for that amount.
Related Questions
How much does a 1031 exchange cost in California?
Costs split across three providers: the qualified intermediary’s fee, the CPA’s filing work, and legal fees for structuring and the two closings. Bay Legal offers flat-fee pricing on many transactional matters. Reverse and build-to-suit exchanges cost more because they require an Exchange Accommodation Titleholder.
Can I exchange California property for property in another state?
Yes. Like-kind treatment does not stop at the state line. But the California clawback and the annual FTB Form 3840 obligation both attach, and they follow the deferred gain until the replacement property is sold.
Do I need an attorney if I already have a qualified intermediary?
A QI holds funds and administers the exchange mechanics. A QI does not negotiate your purchase agreement, examine title, or fix a same-taxpayer problem in your entity structure. Those are legal questions, and they are where exchanges usually break.
What is an Exchange Accommodation Titleholder?
A special-purpose entity that temporarily holds title to either the replacement or the relinquished property during a reverse or build-to-suit exchange, so the two sides of the transaction do not have to close simultaneously.
How long do I have to hold the replacement property?
The Internal Revenue Code sets no fixed holding period for an ordinary exchange, only the requirement that the property be held for investment or business use. Related-party exchanges are the exception and carry a firm two-year hold on both sides.
Talk to a California 1031 exchange attorney
Exchange structure is decided before the relinquished property closes, not after. To review a proposed exchange, a QI agreement, or a replacement property with a Bay Legal attorney, call the office nearest you or email intake.
Bay Legal, P.C. — serving California statewide
Northern California office
667 Lytton Ave Ste 3, Palo Alto, CA 94301
Southern California office
3211 Cahuenga Blvd W Ste 212, Los Angeles, CA 90068
Intake: intake@baylegal.com
Fax: (650) 963-0041
Website: https://baylegal.com
This page is general information about California and federal law and does not constitute legal or tax advice or create an attorney-client relationship. Bay Legal, P.C. does not provide tax advice. For advice on your specific situation, contact a licensed California attorney and a qualified tax professional.