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When you sell your personal residence (the house you live in), the IRS says $500,000 of the gain ($250,000 if you’re single) is tax free. There are some things that you have to do to qualify for this benefit, the most important of which is that you must live in the house for at least two of the last five years.

There is a different code section, Section 1031, that says if you sell a house that’s been a rental for at least the last year (or two years in some situations), you can roll the gain from the old house to the new house and defer the tax on the gain until you sell the new house.

Sometimes these two IRS rules overlap. For example, when you sell your residence, it has to have been your residence for two of the last five years. Two of the last five… so what was happening during the other three years? Well, if you’ve lived in the house for all five years there’s no problem – just sell the property and $500,000/$250,000 of gain is forgiven.

What is a 1031 Exchange?

People ask, “Why should I do a 1031 exchange?” I can answer this question in two words: "Financial Leveraging." By doing a 1031 exchange, the taxes you would have paid to the government are now working to earn you money.

A 1031 exchange allows a taxpayer to postpone their long-term capital gains tax when selling an investment property by exchanging both the basis and the gain into a new investment property. This gives an investor financial leverage. If you have a property used for investment or business and you plan on buying another property used for investment or business, then yes, you need to do a 1031 exchange.

The IRS has granted special relief for taxpayers whose exchange was impacted by Hurricane Ian. If you are doing a 1031 exchange anywhere in the State of Florida on property that you sold, bought or are buying, or you live in the State of Florida, the IRS has automatically extended your 1031 deadlines. After the closing of the sale of your old property, IRS law requires that within 45 days you give the agent handling your exchange a list of properties you might buy to complete your exchange, and then requires that you complete the purchase of at least one of those properties within 180 days. The Disaster Relief extends these deadlines.

Several years ago, the state of California adopted a claw-back rule for 1031 exchanges when the sale property is in the State of California and the replacemnet property is in a different state.

Like most states, California does not tax sales of real estate when the taxpayer does a 1031 exchange and rolls the gain over to a replacement property. Typically, when you sell a property in one state and buy in another state (doing a 1031 exchange), the selling state loses the tax revenue that would have resulted from the sale if it were not a 1031 exchange. 

Several years ago California broke with that tradition and revised their 1031 law to hold that when the taxpayer ultimately sells the property in the replacement state in a taxable transaction, the taxpayer must report the original gain to California and pay tax on it. For example, Sue sells a rental property in California and rolls a gain of $100,000 into a property in Denver, Colorado by doing a 1031 exchange.