Thinking about Selling Your Rental Property? So Are Many California Landlords
And a 1031 Exchange is an
Increasingly Popular Exit Strategy
If you are a California landlord thinking about selling your rental property this year, you are definitely not alone. While owning investment property in the Golden State has its appeal, several factors are motivating many landlords to sell their rental property in 2022: California now leads the nation in outward migration, and the state’s landlord-tenant laws are increasingly viewed as unfavorable toward landlords.
California’s high capital gain tax – currently the highest in the nation – is no longer a disincentive to sell investment property as tax-deferred exit strategies, such as 1031 Exchanges, are gaining tremendous popularity. A 1031 Exchange allows Landlords to sell their investment property without the tax liability and better position themselves to achieve financial and lifestyle objectives on the reinvestment.
These factors, along with potentially unfavorable economic conditions and tax law changes on the horizon, are motivating California landlords to take a closer look at selling their investment property sooner rather than later. Here is a look at the primary factors driving the trend:
California Leads the Nation in Outward Migration
California was once seen as the prime state in which to buy investment property. As the epicenter of population growth in the U.S., the state saw steady population growth since its founding in 1850, that is, until this past year.
According to the San Francisco Business Journal, Census data shows California as having the largest domestic out-migration of any state – with over 367,299 residents leaving as of July 1, 2021. What is fueling this huge shift? For many, life is simply not affordable in California. The average price of a single-family home has increased 23.9% from a year ago. With more people than ever working from home and without the need to live within a commutable distance of one’s employer, they are trading in their high California rent for a more affordable, out-of-state property.
Although 2021 is the first year there has been a reported decline in population, California steadily lost people to other states for years. According to the Public Policy Institute of California, from 2010 to 2020, California lost 6.1 million residents to other states compared to only 4.9 million who relocated to California. The outward migration is driven extensively by high living costs, including the nation’s highest state income tax, and showcases the real economic challenges faced by many in a post-pandemic world.
California Landlord Laws Among the Least Favorable in the U.S.
Each state has it own landlord/tenant laws. While may statutes and civil codes are similar, there can also be some significant differences in the statutes. Some states’ laws, such as California, clearly favor tenants while others are more balanced in their approach.
California landlord/tenant laws are considered by many to be the least favorable to property owners in the country. While it is uncommon for cities to impose additional landlord/tenant rules on top of the state laws, two of America’s largest cities, San Francisco and Los Angeles, have implemented aggressive restrictions for landlords on top of state law. As a result, they are ranked as two of the most anti-landlord cities in the U.S.
The California Tenant Protection Act put into action in 2019 created rent control and eviction laws that affect most residential properties, including those in Los Angeles and San Francisco. In fact, over 85% of L.A.’s rental units fall under rent control, and in San Francisco, the last rent increase was restricted to a meager 0.7%. Additionally, California landlords are required to have “just cause” in order to terminate their tenancy.
It is important for anyone who owns residential rental investments to know how the state-specific landlord laws and city-specific landlord laws might impede their financial growth.
California Has the Highest Capital Gains Tax in the U.S.
Why are 1031 Exchanges So Popular with California Landlords?
The main benefit of selling a rental property with a 1031 Exchange is the deferral of the high tax liability facing California landlords. The deferred tax liability on the relinquished property means more of the net proceeds can be reinvested intoeplacement property. A 1031 Exchange also enables the investment property owner to select a more favorable location and type of replacement property, better positioning the owner to address their financial and lifestyle objectives.
Owners can also use a 1031 Exchange to transition from properties requiring active management to investment real estate that can generate passive income, like management-free 1031 Delaware Statutory Trust properties. For example, a multi-family rental property could be exchanged for fractional ownership in a significantly larger institutional quality Class-A multifamily property, an industrial property, a portfolio of medical office properties, or a combination of – all managed by institutional real estate firms. Selling one property and reinvesting the proceeds into multiple 1031 Exchange replacement properties can also diversify the risk inherent in owning a single property.
How Does a 1031 Exchange Work?
A 1031 Exchange, also known as a “like-kind” Exchange, gets its name from Section 1031 of the U.S. Internal Revenue Code. By performing a 1031 Exchange, you can sell investment real estate without paying capital gains tax if you reinvest the sales proceeds into like-kind investment property of equal or greater value and adhere to IRC 1031 rules and timing requirements. Because the IRS defines “like-kind” as any real estate held for business or investment purposes, you can exchange any investment real estate for other investment real estate regardless of the property type.
Although 1031 Exchange can be an excellent tool to defer capital gains, depreciation recapture, and net investment income taxes following the sale of an asset, they can also be complicated transactions. While 1031 Exchanges are flexible in the number of strategies that can be implemented, the rules put forward by the IRS are not flexible. Failure to adhere to IRS rules can result in either a failed Exchange, in which the entire tax liability is due, or a Partial Exchange, in which a portion of the tax liability is due (generally the most expensive portion).
Before selling investment property, investors considering a 1031 Exchange should become familiar with how 1031 Exchanges work, including IRS rules and timing requirements. To learn more about 1031 Exchanges, download our FREE guide, Understanding 1031 Exchanges.
Is a 1031 Exchange a Suitable Option for Me?
If you’re considering selling your California rental property, a 1031 Exchange could be an excellent option and offer many benefits, including the ability to grow wealth.
Understanding the tax liability on your relinquished property is generally the first step in the 1031 Exchange process. This will help you compare the net proceeds for reinvestment with or without a 1031 Exchange.
It is also critically important to understand 1031 Exchange rules and the timeline for an Exchange before getting started. IRS exchange rules are very rigid, and the 1031 exchange timeline must be strictly followed to qualify for tax deferral.
Setting financial and lifestyle objectives are also critical steps with every 1031 Exchange. Ultimately, the replacement properties you’re exchanging into should align with your key objectives, including risk tolerance, cash flow, appreciation goals, liquidity, desire for management control, and estate planning needs.
Consider consulting a licensed 1031 Exchange Advisor before selling your investment property to ensure compliance with 1031 Exchange rules, a detailed understanding of your tax liability, and the availability of suitable 1031 replacement properties that meet your financial and lifestyle goals.