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Accounting for 1031 Exchanges in California

April 27, 2024

Accounting is an important aspect of real estate transactions in California, especially for 1031 exchanges. If you want to maximize the tax benefits of a 1031 exchange, you have to keep an accurate record of every transaction in the exchange. Maintaining accuracy in your record-keeping of your 1031 exchanges, which include delayed exchanges, reversal exchanges, etc., can prevent you from being disqualified from the exchange. In addition to keeping accurate records, you should work with an experienced, qualified intermediary who can provide expert guidance and support.

At Universal Pacific 1031 Exchange, we’re here to help you boost your investment returns by lowering your tax liabilities. Our experienced, qualified intermediaries are always available to help you leverage the tax deferral benefits of a 1031 exchange and guide you throughout the exchange. Book a free consultation with us today to get started.

In this blog, you’ll learn how to account for 1031 exchanges in California and the various tools that can make the process easy and efficient.

Basics of 1031 Exchanges

Basics of 1031 Exchanges

A 1031 exchange, also called a like-kind exchange or starker exchange, is a tax deferral strategy for real estate investors and property owners. It allows taxpayers to swap one investment property for another similar property without paying immediate capital gains taxes on selling the relinquished property. 

In a 1031 exchange, instead of paying taxes on any profit you get from selling your property, you can reinvest the entire proceeds of the exchanged property into purchasing a replacement property. This allows the IRS to roll over the postponed gain from the sale to the newly acquired property, thus avoiding immediate taxation of the realized gain.

Not all properties qualify for this exchange except for properties held for trade, business, or investment purposes. Personal property, such as your primary residence or vacation home, does not qualify.

However, taxpayer’s primary residences and vacation homes may qualify if they meet certain IRS criteria. Also, stocks, bonds, inventory, and other financial securities do not qualify for a 1031 exchange. Note that the 1031 exchange only defers capital gain tax and not other taxes like the transfer tax.

Accounting for 1031 Exchange

Accounting for 1031 Exchange

When performing a 1031 exchange, you may need to record all the exchange transactions and adjust your property’s basis accurately to ensure that you’re complying with tax rules. It involves filling out the entries for your relinquished property, deferred gain, and replacement property.

To avoid facing challenges, hire a Certified Public Accountant (CPA) or tax adviser. They understand tax implications and can structure your exchange to ensure compliance with tax rules. Also, a tax accountant and CPAs accurately document your tax returns and financial statements in a 1031 exchange.

Overview of different 1031 exchange types

There are several types of 1031 exchanges, each with its own unique accounting procedures. They include simultaneous exchange, delayed exchange, reverse exchange, and improvement exchange.

In a simultaneous exchange, you can only sell your relinquished property and buy a replacement property in one day. A delayed exchange is the commonly known starker exchange where you sell your property, identify replacement properties within 45 days, and then purchase the identified property within 180 days. On the other hand, a reverse exchange involves buying a replacement property first before you sell the relinquished property.

When conducting these exchanges, you must hold both properties for at least two years for investment or business use to qualify for the exchange. Technically, this means you can live in your newly acquired property after two years.

Lastly, the construction or improvement of a 1031 exchange demands that you sell your property and reinvest the sale funds to finance the construction or improvement of a replacement property. Like the delayed exchange, it begins by selling your relinquished property, identifying a replacement property within 45 days, and then using the sale funds to finance the improvement of the replacement property. To legally defer capital gains taxes, you must complete the improvement within 180 days after the day you sell your relinquished property.

Accounting for Like-Kind Exchanges

Accounting for like-kind exchanges means adjusting your account records to reflect the sale of your property, deferred gain, and the purchased replacement property. The process can be complex and will require careful attention to detail, especially when dealing with a drop-and-swap 1031 exchange that entails swapping partnership interests for a replacement property.

Examples of entries to include in your exchange account are those for relinquished property, replacement property, deferred profit or loss, and additional expenses related to the exchange. In the initial entry for the old property, include the debit of the total depreciation you’ve claimed on the property and the original property cost. This initial entry removes the relinquished property’s cost from the books. 

When it comes to recognizing deferred profits and losses, record them as a memo entry in your accounting journal. Note that for income tax purposes, you don’t need to recognize deferred gains or losses on your income tax return until you sell the acquired property. 

Lastly, the entries for the replacement property include the fair market value of the replacement property recorded as a credit, the amount of accumulated depreciation for the exchanged property, and any additional cash you credited into the account for identified replacement properties.

Furthermore, keep records of other exchange-related expenses, such as closing costs, intermediary fees, etc. To report your like-kind exchange, use Form 8824 and attach it to your tax return in the same tax year as the exchange.

Accounting for Delayed 1031 Exchange

Accounting for Delayed 1031 Exchange

When recording transactions for a delayed 1031 exchange, you need specific accounting practices, such as accounting for the deadlines for identifying and acquiring replacement properties, to accurately reflect the transaction. Here are some bookkeeping entries you may need:

  • For entries on the Initial Sale of Property:
    • Debit: Cash proceeds from the sale
    • Credit: The cost basis of the property 
    • Credit: Accumulated depreciation, if applicable
    • Credit: Capital Gain or Loss on the sold property
  • For entries of acquiring the Replacement Property within 180 days after the sale:
    • Debit: Cost basis of the replacement property
    • Credit: funds for purchase from the exchange account
    • Credit: All additional funds needed to complete the purchase
  • For Deferred Gain entries:
    • Debit: Deferred Gain (a liability account) 
    • Credit: Capital Gain or Loss to adjust for the deferred gain

Accounting for 1031 Reverse Exchange

A 1031 reverse exchange has its own unique accounting practices and entries since it involves buying another property before selling off your relinquished property. Here, you record the entries of the replacement property first before those of the relinquished property. Examples of its bookkeeping entries include:

  • For the purchase of replacement property:
    • Debit: Cost basis of replacement property
    • Credit: Cash loan for buying the replacement property
    • Credit: Due to Exchange Accommodator (a liability account) 
  • Transfer of Relinquished Property to EAT:
    • Debit: EAT (transfer of relinquished property to the accommodator)
    • Credit: Cost basis of the relinquished property
    • Credit: Accumulated Depreciation, if applicable
    • Credit: Capital Gain (or Loss) on the sale
  • Sale of Relinquished Property by EAT:
    • Debit: Cash proceeds from the sale of the relinquished property
    • Credit: Funds released by the exchange accommodator for the exchange
  • Accounting for Deferred Gain:
    • Debit: A record of Deferred Gain (a liability account) 
    • Credit: capital gain (or loss) to adjust for postponed gain.

Accounting for 1031 Improvement Exchange

A 1031 Improvement Exchange demands that you first acquire replacement property and then construct improvements before you sell off the relinquished property. When accounting for an improvement exchange, take records of the property purchase transactions, followed by any improvements made, and lastly, the processes involved in selling the relinquished property. Some possible entries you may want to include in your account include the following:

  • Acquisition of Replacement Property:
    • Debit: Cost basis of replacement property
    • Credit: Cash loan for buying the replacement property
    • Credit: Due to Exchange Accommodator (a liability account) entries:
  • Construction of improvements:
    • Debit: Cost of ongoing construction improvements (an asset account) 
    • Credit: Cash (or Loan) for construction funds 
    • Credit: Accounts Payable for any debts incurred from construction (if applicable) 
  • Transfer of Relinquished Property to Exchange Accommodator:
    • Debit: EAT (transfer of relinquished property to the accommodator)
    • Credit: Cost basis of the relinquished property
    • Credit: Accumulated Depreciation, if applicable
    • Credit: Capital Gain (or Loss) on the sale
  • Sale of Relinquished Property by Exchange Accommodator:
    • Debit: Cash (proceeds from the sale of the relinquished property) 
    • Credit: Due to Exchange Accommodator (to release funds held in their custody)
  • Accounting for Deferred Gain:
    • Debit: Record of all Deferred Gain (a liability account) 
    • Credit: Capital Gain (or Loss) to adjust deferred capital gains

Disclaimer: These entries are examples of simple exchange transactions. They may vary depending on the specific circumstances of the exchange. Always seek counsel from an accountant or tax professional to be sure your transaction records are accurate and compliant with tax regulations.

Common Accounting Challenges in 1031 Exchanges

Common Accounting Challenges in 1031 Exchanges

The procedures involved in accounting for 1031 exchanges can be complex and prone to errors. Hence, you may encounter certain challenges while accounting for 1031 exchanges.

First, you’re likely to have a wrong valuation of your property if there are errors in your calculations. Incorrect property valuation may also result in wrong estimation of gain or loss, basis, depreciation, and tax liability – and errors in these values may lead to incorrect tax reports which may ultimately attract penalties from the IRS.

As such, it’s best to independently evaluate your properties to determine their fair market value and avoid any discrepancies. If there are differences between the appraised property value and the agreed-upon value, find a way to adjust your accounting entries. Consult with your qualified intermediary or a qualified appraiser to figure out the right adjustments to make.

Secondly, it may be difficult to identify replacement properties within the specified timeframe. Recall that missing the 180-day exchange timeline disqualifies you from enjoying the tax benefits of the exchange. To prevent this, monitor 1031 exchange deadlines very closely. Make sure to identify replacement investment properties before the 45-day deadline elapses and keep detailed records of all the identified properties. Also, keep track of the 180-day deadline and ensure you complete the property exchange within the timeframe.

Additionally, inadequate or insufficient records, especially for improvement exchanges may cause audit issues or jeopardize your like-kind exchange. Thus, ensure to keep accurate and detailed records of every transaction.

Tools For Keeping 1031 Exchange Accounting Books Organized

Tools For Keeping 1031 Exchange Accounting Books Organized

When you’re accounting for the sale and purchase price of your real property, you can use accounting tools to generate accurate transaction reports that cover the relevant details of the exchange. These tools also make tax reporting for real estate investments easy. They include QuickBooks, Xero, Wave Accounting, etc.

For example, with QuickBooks you can accurately report your taxes, efficiently manage your 1031 exchange financial transactions, and effectively track any asset transfers and management. These help you align your financial records with the internal revenue code for 1031 exchanges.

Other bookkeeping options involve using DIY spreadsheet tools such as Microsoft Excel or Google Sheets. With these spreadsheets, you can create custom templates for tracking 1031 exchange transactions, depreciation, and capital gains or losses.

For exchanges involving complex transactions, you should consider working with our Certified Public Accountant (CPA) at Universal Pacific 1031 Exchange. We provide personalized accounting guidance to ensure that your exchange complies with IRS requirements.

Tax Implications and Reporting Requirements for 1031 Exchange

To effectively plan and manage your exchange within IRS rules for tax purposes, you must understand the tax consequences and implications of using a 1031 exchange. This helps you reap the full benefit of delaying tax payment on the sale of qualified properties, so long as you reinvest the sale proceeds into buying a like-kind property before the specified deadlines. This gives taxpayers the opportunity to protect their taxable income from taxes, thus lowering their overall real estate taxes.

1031 exchange also defers taxes on gains associated with depreciation recapture. When you exchange a depreciated property for another one that will be depreciated, any gain from the sale is automatically taxable. However, you can delay paying this tax through a 1031 exchange.

Speaking of tax reporting on your 1031 exchange, you must comply with federal and state-specific tax reporting requirements to correctly report your exchange. As a taxpayer, you must report your like-kind exchange on Form 8824 and attach it to your federal income tax return that same year you made the exchange.

In California, you must report your exchange on FTB 3840, provided that it’s an exchange between real properties in California and real properties outside California. You are also required to file the FTB 3840 the same year the real property exchange occurred and each year after the exchange until the deferred profits or losses are recognized.

How to Keep the Books: Accounting for 1031 Exchanges

How to Keep the Books: Accounting for 1031 Exchanges

To fully understand accounting practices for exchanges, let’s look at some examples. John gave up his property worth $50,000 for another like-kind property worth $40,000 through a 1031 delayed exchange.

Since the new property is less valuable by $10,000 than the relinquished property, John will receive a taxable boot. Here’s John’s record entry for his transaction:

  • Debit: 
    • New property = $40,000
    • Cash = $10,000
    • Loss on Exchange = $10,000
  • Credit: for
    • Relinquished property = $50,000

Therefore, when conducting a 1031 exchange, avoid any cash boot by reinvesting all your exchange proceeds in purchasing another property. This helps you to completely benefit from the exchange.

But, what if John made an error while calculating the adjusted basis of the sold property? This can result in discrepancies in the exchanged property’s value and cause incorrect accounting and reporting of the exchange. To avoid this, he consulted with a CPA, who recalculated his adjusted basis and adjusted his bookkeeping entries.

Another example is Laura’s exchange. She swapped her commercial office building property in California for a vacant lot valued at $300,000. She then invests an additional $200,000 to construct a new commercial office and apartment building on the lot, according to IRS guidelines.

In Laura’s accounting entries, she recorded a debit due to the vacant lot and the construction or improvement in progress. When she completed the construction, she then recorded a credit due to the construction in progress account and a debit on the property construction account.

Best Practices in Accounting for 1031 Exchanges

To ensure your records are accurate and your exchange complies with IRS rules, use accounting software or spreadsheets and document every transaction that takes place in the exchange. Bookkeeping software helps you accurately calculate your property value, depreciation, and other basic calculations. 

It’s crucial to choose a reputable Qualified Intermediary who can provide clear instructions and documentation in the exchange process. Always communicate with your QI concerning your exchange. To be certain, verify that your QI or escrow agent keeps your sale funds in a qualified escrow account.

Not Sure How to Make the Most out of a 1031 Exchange?

Planning your exchange meticulously helps you track aspects of your 1031 exchange, such as capital gains, investment property values, depreciation, etc. By obeying IRS guidelines, you can avoid costly mistakes and prevent any IRS audits.

You can also use accounting software to ensure there’s accuracy in your transaction records. By following these practices and working with an experienced CPA and qualified intermediary, you can easily defer capital gains tax. 

Our licensed Los Angeles CPA professionals at Universal Pacific can provide you with personalized guidance to ensure that you properly account for your 1031 exchange and comply with all federal and state laws. We’re committed to helping you complete a smooth and compliant tax-deferred exchange. Take the first step and start an exchange with us today by scheduling a complimentary consultation call with us.

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.