1031 CA to TX, purchase to be built home

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1031 CA to TX, purchase to be built home

Nancy Brewer
Member since 2021 · 3 posts · 1 vote

We had several rentals in CA and downsized and moved to TX to be closer to our daughter. We have one house left that has been rented for about 16 years. The house is large and will be easy to sell in the current market. Our intention is to use a 1031 on it for like kind, a new house to be built, here in booming Conroe TX. We currently live in a house here that we own free and clear. Our plan is to rent our current home and move up to the yet to be built house. 

That being said we are wanting to check with experts on if this will work, if:

1. We are living in the house they we funded by the 1031.
2. Will builders accept the earnest money and the funds from the exchange? Do they normally have QI who help buyers, or should we find our own? Builders are national companies.

3. Will the CA Claw apply? Can someone explain that for me?

4. What if construction is held up? How does that work if it runs over that 180 day time? 

Thank you for your replies!

Nancy


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Bill ExeterBusiness Member
1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
5y

Hi @Bill B., 

No, the conversion to a primary residence is not considered a taxable sale.  

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  • Bill B.
    Investor · Las Vegas, NV · Member since 2013 · 8k+ posts · 10k+ votes
    5y

    You’ll want to talk to @Dave Foster or one fo the other 1032 exchange experts on here but...

    My layman’s understanding is...

    If you ever sell anything you exchanged out fo California they’ll clawback their state income tax. 

    It’s VERY doubtful you could buy land and build a home within your 180 days, especially in Texas. you would probably have to front all the money out of pocket through a QI and do a reverse exchange. 

    BUT, the biggie is, you can’t build it and move right in to it. That’s not a 1031 exchange for investment purposes. You’re going to owe all the capital gains and depreciation recapture taxes. There’s no reason to pay fo a 1031 if that’s your plan. 

    Talk to an expert if you’re talking about 10’s or even 100’s of thousands of dollars where mistakes once 

    1Reply
  • Bill ExeterBusiness Member
    1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
    5y

    Hi @Nancy Brewer, 

    Here are answers to your questions. 

    1) The house that you acquire through the 1031 Exchange must be held for rental, investment or business use.  It would not qualify if you live in the house as your primary residence.  You can certainly acquire the replacement property as rental property and then after a couple of years decide to change your intent and convert it to your primary residence, but your initial intent and usage must be rental or investment. 

    2) It will depend on the community and the builder. Many will accept earnest money deposits (EMD) and will work with Qualified Intermediaries. They rarely have a relationship with a Qualified Intermediary, so you would need to choose your own Qualified Intermediary.

    3) Yes, the California Claw Back will apply.  California has always taken the position that it is tax deferred as long as you keep exchanging, but as soon as you cash out they will want their share of the taxes.  You also have to file an annual information return with the California Franchise Tax Board to report that status of the property. 

    4) There are no extensions of time, so if the construction takes longer than 180 calendar days you will have a failed 1031 Exchange.  There are no Federal or state penalties for a failed 1013 Exchange, but you will pay the taxes.  This is one of the risks with new construction.  

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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    5y

    @Nancy Brewer, At first blush there's nothing wrong with your plan as long as a couple details are met

    1. You can't move right into that new construction.  Your intent in purchasing it must be to hold for productive investment use and then you "convert" it to your primary residence.  There's no statutory period for this but there is a a safe harbor from the IRS at 2 years.  Most folks feel pretty comfortable at a period of more than a year before moving in full time.

    2. The type of loan does not matter in your 1031.  It is the actual use of the property that matters to the IRS But beware that your lender will probably not lend to you at primary residence rates if the down payment is coming from a 1031 exchange.  There are a number of lenders who will lend to you as a 2nd home which is almost as advantageous and gives you the flexibility to hold the home as an investment that you use for some personal use.

    3. In theory the CA clawback will apply because you are required to file an annual report with the Franchise Tax Board as long as you own that or subsequent property that you 1031 into.  It will be very interesting to see how this shapes up in the near future as there are a number of bright aggressive attorneys who don't think the clawback can legally apply to a non-CA resident owning non-CA property even if that property was once a CA property.  In their view it's going to be awfully hard to charge and collect tax on the sale of a Non-CA property by a Non-CA resident.  So stay tuned on that.

    4. We're dealing with builders and their bad calendar math every week now.  It's a real problem.  4 months in order to get a contract  means 6 months until it really means 8 months.  And the client is the one who pays the price because your 1031 will not be extended just because your builder over promised and under delivered.  Here are a couple tips to mitigate this however.

         a. The property doesn't have to be completed or even has a CO (gotta watch for lending issues however) in order for you to take title to complete your exchange.  It only has to be worth enough to satisfy your reinvestment requirements.  So if your sale was $500K and your completed property was going to cost $750 then you could take title to it when it was 2/3rds complete and have a private agreement with the builder to complete it.

         b. One thing we're trying to really emphasize strongly is that we are in such a sellers market that you should wait until the construction is 3-5 months along before listing and selling your old property.  Or sell the old property with a contingency for an extended closing date.  This way the building will be much more likely to be complete within 180 days of your sale since the builder is getting such a head start.   You can go into contract for your new property before your old property closes.  You just have to close the sale of your old property before you close the purchase of your new property.

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  • Bill B.
    Investor · Las Vegas, NV · Member since 2013 · 8k+ posts · 10k+ votes
    5y

    @Bill Exeter

    Quick question in the vein of this discussion. Will California come after them for taxes if/when they change this 1031 in to a primary? Or not until they sell it? (They say they are living in a previous 1031 exchange already so assuming that was also California based maybe they wait until a sale rather than just a re-characterization?)

    I was just wondering since you said they would have to file a report with California every year. 

    2Reply
  • Bill ExeterBusiness Member
    1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
    5y

    Hi @Bill B., 

    No, the conversion to a primary residence is not considered a taxable sale.  

    Exeter 1031 Exchange Services, LLC and Exeter Trust Company4.726 Reviews
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    2Reply
  • Nancy Brewer
    OP
    Member since 2021 · 3 posts · 1 vote
    5y

    I want to thank you all for the thoughtful responses to my questions! There are some eye opening things we need to consider.

    Nancy

    1Reply
  • Nancy Brewer
    OP
    Member since 2021 · 3 posts · 1 vote
    5y

    One more question. We owe about $230,000 on the property and it is worth about $650,000. If the CA claw applies how much tax and/or capital gain would we owe?

    0Reply
  • Bill B.
    Investor · Las Vegas, NV · Member since 2013 · 8k+ posts · 10k+ votes
    5y

    Nancy, what you owe has nothing to do with the taxes due, only the amount of cash you will have to reinvest to stay “boot” tax free if you go forward with the 1031 exchange. 

    If you eventually sell or get taxed. You will pay capital gains tax on your net sales price minus your net purchase price plus a 25% depreciation recapture tax. 

    0Reply
  • Kali Hoteroton
    Member since 2021 · 2 posts · 0 votes
    5y

    @Bill Exeter

    For clarification, if someone:

    1st: owns in CA

    2nd: 1031 exchanges into TX

    3rd: rents TX property for several years

    4th: later converts to a primary residence

    then the claw back provision expires once it becomes a primary residence?

    0Reply
  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    5y

    @Kali Hoteroton, There's quite a bit of nuance and "what if"s in that scenario.  Because as Bill noted, the conversion itself is not a taxable event.  However, the question becomes one for down the road if you ever sell after converting some other things come into play.

    1. Because the property was once investment, and was the product of a 1031 exchange you will have to have owned it for 5 years before selling if you want to get the primary residence exclusion.  And when you do sell that way you only get to take a proration of the gain tax free under federal law and you have to recapture depreciation.  So the assumption is that CA will want to also claw back it's portion of the gain at that point as well.  Since. you've been reporting it annually to the FTB - unless you haven't

    2. There are more and more bright legal folks questioning the constitutionality of CA attempting to collect tax from a resident of another state.  And the questions of how they track you if you're no longer a CA resident.  And how they enforce it if you're no longer a CA resident...  It starts to get very murky what will happen.

    But if you just start with the 1031 out of CA and into TX and then the conversion into your primary you're OK under current law.

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  • Bill ExeterBusiness Member
    1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
    5y

    Hi @Kali Hoteroton, 

    California will still attempt to collect taxes if and only if you sell the primary residence down the road.  The 121 Exclusion would likely help, but until someone challenges the 121 Exclusion as non-taxable it is what it is. 

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    0Reply
  • Kali Hoteroton
    Member since 2021 · 2 posts · 0 votes
    5y

    @Bill Exeter

    If/when I sell the TX property, then the CA prop will be taxed at the market value when the TX property is sold, correct?

    Example:  If the value of the CA prop =$300K when I exchange it for another in TX, but appreciates to $500K by the time I sell the TX property, then I would be taxed on the $500K in CA, correct?

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