Section 1031 exchanges are a popular means of deferring taxation on commercial property. Suppose in 1970 you purchased a commercial property in Los Angeles for $500,000. You decide to sell it, and discover that it’s now worth $2.5 million. One way of avoiding paying capital gains tax on the gain is to use §1031 of the Tax Code to defer that gain. (There are lots of requirements with §1031, including using a qualified intermediary, specific dates for the exchange, etc. that must be met.)
Nothing in the Tax Code prohibits you from taking that property in Los Angeles and exchanging it with a property in, say, Jacksonville, Florida. Indeed, there is no state tax in Florida. Additionally, California does not have preferential tax rates on capital gains; that $2 million gain would be taxed as ordinary income, reaching the (current) 13.3% marginal rate.
You’re probably ahead of me: One method that some tax professionals have used is to perform a §1031 exchange from California property to non-California property. If the taxpayer then leaves California (or if he is a non-Californian), the Franchise Tax Board (California’s income tax agency) has no method of going after the gain. California’s legislature didn’t like that, so Sections 18032 and 24953 were added to California’s Revenue and Taxation Code. (§18032 is for individuals while §24953 is for corporations.)
Beginning for years on January 1, 2014 and after, Californians and non-Californians will be required to file annual reports after exchanges of §1031 property. The form(s) do not yet exist; presumably, taxpayers will have to acknowledge that they still own the new property (or a successor property if another §1031 exchange has occurred). The statutes authorize the FTB to assess tax if a report is not filed.
