In a housing crisis, California looks to alter 1031 Exchange programs

California has never met a tax it didn't like to impose on its citizens.  Even when the economy is in massive recession, and house prices in the state are falling drastically, they cannot help but get their fingers into the real estate market and find ways to get more money for their coffers.

This appears to be the course of action California is taking for investors and home sellers who simply desire to move onto a new property.  One of the tax incentives that home sellers have is a 1031 Exchange, and this is the crux of what California is going after.  In a 1031 Exchange, a home seller can hold off on paying taxes for the sale, if they move into a new property within a certain amount of time.

1031 Exchange:

A 1031 exchange, otherwise known as a tax deferred exchange is a simple strategy and method for selling one property, that's qualified, and then proceeding with an acquisition of another property (also qualified) within a specific time frame. The logistics and process of selling a property and then buying another property are practically identical to any standardized sale and buying situation, a "1031 exchange" is unique because the entire transaction is treated as an exchange and not just as a simple sale. It is this difference between "exchanging" and not simply buying and selling which, in the end, allows the taxpayer(s) to qualify for a deferred gain treatment. So to say it in simple terms, sales are taxable with the IRS and 1031 exchanges are not. US CODE: Title 26, §1031. Exchange of Property Held for Productive Use or Investment

This is one of the programs created to spur real estate growth, and to help the market move with more fluidity.  By being allowed to defer taxes until the final property is sold, it allows home owners and investors to move up in property, and make a market for higher priced deeds.

California however, is seeking to circumvent the entire process that has been allowed to flow between states.  In a new piece of legislation, the state is seeking to impose up front taxes at the initial sale unless the property owner purchases new property in California.

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. - California Law Report

The total amount of tax revenue garnered by the state would be very small compared to their budget deficit, but the overall affect on their housing industry would be colossal.  Reciprocity is an act that allows citizens of one state to keep their rights when travelling through another state, and if California chooses to pass this bill, then investors from outside California will think long and hard about investing in property there because it limits their tax incentives.