Proposed Legislation Would Change 1031 Exchange Programs

With California facing another year of record budget deficits, Legislators in Sacramento have been looking for anything they can find to fill the budget gap.

One such proposal currently being debated in the State Capitol would attempt to raise revenues by modifying one tax deferral program which has been popular with real estate investors.

“1031 exchange programs” allow owners of appreciated investment properties to defer capital gains tax on the sale of their property if the taxpayer acquires like-kind replacement property within the requirements of Section 1031.  The federal tax rule essentially allows real estate investors to defer paying taxes on the sale of their investment properties as they exchange upwards to larger properties over the years.

The new bill, SB 1316 (Romero) would change Section 1031 so that if California property is sold through a 1031 exchange, the replacement property must also be located in California, or the state will not recognize the tax-deferral on the transaction.

Sen. Romero has explained the legislation as aiming to assist California’s economic recovery by stimulating further investments within the state.

“California currently offers a range of tax credits that are of no direct benefit to the state,” said Romero.  “With our economy still faltering, it’s a more prudent use of General Fund dollars to stimulate direct investment in California and not to subsidize private investments outside the state.”

If the legislation is enacted as proposed, the limitation on deferral would apply retroactively to all exchanges initiated after January 1, 2010. Property owners who sold or sell investment real property could continue to defer state income tax for exchanges of property if the replacement property is located within California.

Sen. Romero’s office has estimated that SB 1316 would save California approximately $44 million each year. That’s no small potatoes, but it also won’t go too far towards filling California’s $19 billion budget deficit.

Perhaps not surprisingly, real estate industry, business, and banking groups such as the California Association of Realtors, the California Apartment Association, California Building Association, and the California Chamber of Commerce have fought aggressively against the proposed bill.

Supporters of the bill have argued that the bill would provide $44 million in tax credit investments to high-poverty, low-income and minority communities, as well as to small businesses in distressed areas.

What do you think of this proposed legislation?  Leave your thoughts in the comments below.

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John Corcoran is an Associate with Plastiras & Terrizzi law firm in San Rafael, California (Marin County).  He advises clients on real estate matters, small business issues, estate planning, and general civil litigation.  He may be reached at [email protected] or (415) 472-8100 x211.

(Photo credit: geograph.org.uk)