Should You Do a 1031 Exchange? The Decision Framework for Los Angeles Investors

QUICK ANSWER: To decide whether a 1031 exchange makes sense for a Los Angeles investor, analyze: (1) tax liability on the sale, (2) current cash flow vs. equity, (3) remaining depreciation, (4) rent control factors like RSO/JCO, (5) liquidity needs, and (6) performance of potential replacement properties. A 1031 exchange typically makes the most sense when the owner faces a large tax bill, has low rents or weak cash flow, or wants to trade into higher-performing, less regulated markets.

⚠️ IMPORTANT DISCLAIMER

This article provides general educational information about 1031 exchanges and Los Angeles real estate investing. It is not tax, legal, or financial advice. Tax laws vary by jurisdiction and individual circumstances. Always consult with qualified tax professionals, CPAs, and real estate attorneys before making decisions about 1031 exchanges or property sales. Tax rates referenced are approximate as of 2024.

Why This Decision Is More Complicated in Los Angeles

Deciding whether to execute a 1031 exchange is not as simple as "Do I want to pay taxes or not?" In Los Angeles, the decision is layered with: • Rent control (RSO) • Just Cause Ordinance (JCO) • AB 1482 statewide caps • Below-market rents • Legacy tenants • Properties that have appreciated faster than they've cash-flowed That's why LA investors often get stuck: the property is worth a fortune on paper… but performs terribly in real life. This article walks through the exact decision framework to use when an LA investor asks: "I own a $1.5M rental. I've got about $400K in gains. Should I exchange or just sell?" Here's how to break it down.

Step 1: Analyze the Investor's Schedule E (The Real Performance Test)

Every decision starts with your Schedule E, because it reveals two things the MLS never will: 1. Your property's true income Not the rent you could get… Not what your neighbor gets… But what your property actually makes after: • Insurance • Property taxes • Repairs • Maintenance • Management fees • Vacancy rate • Utilities (if applicable) 2. Your true expenses and deductions Especially: • Remaining depreciation • Mortgage interest • Actual operating expenses • Depreciation recapture exposure Why this matters: Most LA investors are shocked when they see their Schedule E next to their property's equity. A $1.5M building bringing in $2,000–$3,000/mo because of long-term tenants is extremely common — and extremely inefficient. A Schedule E tells us if your property is: ✔ Underperforming ✔ Overleveraged ✔ Overstretched by regulation ✔ Out of depreciation ✔ Or genuinely strong Your decision hinges on this foundation. Once you understand your true property performance, the next question becomes obvious:

Step 2: How Much Will You Lose in Taxes If You Don't Exchange?

(Also known as: "What is the tax impact of selling without a 1031 exchange?") This is where things get real. If you sell a $1.5M LA rental with $400K in capital gains, your tax bill may include: • Federal Capital Gains: 15–20% • Depreciation Recapture: 25% • California State Tax: 9.3–13.3% • Medicare Surtax (NIIT): 3.8% In Los Angeles, that's often 32–40% of your gains. On $400,000 of gain, that could be: 👉 $128,000–$160,000 gone. *Tax rates shown are approximate as of 2024 and vary based on income level, filing status, and other factors. Consult a tax professional for calculations specific to your situation.* If you sell without exchanging, your next question becomes: Are you okay giving the government $140K+? Most people aren't.

Step 3: Cash Flow vs. Equity (The Most Overlooked LA Metric)

This is the "return on equity" analysis that most investors overlook. The critical question is: "Is your return on equity better or worse than what you could get with a replacement property?" For many LA owners, the real answer is: "Terrible. I'm sitting on equity that's doing nothing." Here's why: Example: Typical LA 4-Unit Under RSO • Property value: $1,500,000 • Rent roll: $3,200/mo • NOI: ~$20,000–$25,000 • Cap rate: ~1.3%–1.7% On $1.5M of equity, most owners are making: 👉 1–2% return Meanwhile, Sunbelt markets or DSTs offer: • 4–7% cash-on-cash • Newer construction • No RSO/JCO restrictions • Stronger rent growth • Far less tenant friction If your cash flow is weak relative to your equity, a 1031 is almost always the superior move.

Step 4: Depreciation Remaining (Often the Deciding Factor)

Depreciation is one of the largest tax benefits you get as a landlord. A property depreciates over 27.5 years. After that: • You lose a major deduction • Your taxable income increases • Your cash flow becomes less efficient Exchanging resets your depreciation clock So the key question is: "Are you running out of depreciation?" If the answer is yes, the math usually says: 👉 Exchange now. Because resetting depreciation can save you tens of thousands annually in taxes.

Step 5: Rent Control (RSO, JCO, AB 1482)

This is where Los Angeles becomes its own category. If the property is under: • RSO (Rent Stabilization Ordinance) • JCO (Just Cause Ordinance) • AB 1482 (statewide rent cap) Then the investor must answer: Are my rents substantially below market? In LA, many owners have: • Tenants 40–70% below market • No realistic path to increasing rent • Tenants who will not vacate • "Tenant protections stacked on tenant protections" This makes the property extremely difficult to reposition. If your rents are below market and locked in by law, the property is worth less than you think. And the longer you hold, the worse it gets because: • Inflation outpaces rent increases • Repairs get more expensive • Asset becomes more operationally fragile Many investors exchange for this reason alone.

Step 6: Liquidity Needs (Cash-Out Exchange Option)

A lot of investors don't know this: You can do a 1031 exchange and take out cash tax-free. Typically: • $50K–$100K cash-out possible • As long as structured correctly • Without triggering tax • Based on lender guidelines and income profile So the question becomes: "Do you need some liquidity without triggering taxes?" If yes → A 1031 exchange is one of the safest ways to do this. With liquidity considerations addressed, now comes the most critical analysis:

Step 7: Compare Current Property vs. Replacement Opportunities

This is where your Exchange Analysis Spreadsheet comes in. Side-by-side comparisons reveal: Downleg (your current LA property) ✔ Current rent ✔ True cap rate ✔ True return on equity ✔ Remaining depreciation ✔ RSO/JCO constraints ✔ Cash flow efficiency Upleg Options (properties you're considering) ✔ Projected rent ✔ Cap rate ✔ Cash-on-cash return ✔ New depreciation basis ✔ Appreciation trends ✔ Tenant laws ✔ Maintenance timeline ✔ Age of construction Here's what a typical comparison looks like:

Factor	Current LA Property (RSO)	Potential Replacement
Property Value	$1,500,000	$1,500,000
Annual Rent	$38,400 ($3,200/mo)	$82,500 ($6,875/mo)
Cap Rate	~1.6%	~5.5%
Cash-on-Cash Return	1.6%	5.5%
Rent Control Status	RSO/JCO (Yes)	None
Tenant Situation	Legacy tenants 50% below market	Market-rate tenants
Depreciation Remaining	~5 years left	Full 27.5 years (reset)
Property Age	Built 1985	Built 2020
Maintenance Level	High (aging systems)	Low (newer construction)
Management Style	Hands-on required	Professional/passive

This side-by-side reveals the true performance gap most LA investors never see until they run this analysis. Most clients have never seen this comparison in their lives. And almost always, the takeaway is obvious: 👉 "My current property is not performing at the level it should."

When Does a 1031 Exchange Make Sense (And When Doesn't It)?

✔ It makes sense when: • Your tax bill is over $100K • Your cash flow is low relative to equity • You're stuck with long-term tenants • You're under RSO/JCO • Your depreciation is gone • You want newer, more passive assets • You want to scale from 1 property to 2–3 • You want out of California's regulatory framework • You need liquidity but want to avoid taxes ❌ It does not make sense when: • Your gain is small • You're exiting real estate completely • You need cash immediately (full cash-out) • You have little equity • You want to downsize without reinvesting

Hypothetical Example: The $1.5M / $400K LA Investor

The following is a hypothetical scenario based on common situations LA investors face: Property: • 4-unit in LA (RSO) • Current value: $1.5M • Rent roll: $3,200/mo • NOI: ~$24,000 • Cap rate: ~1.6% Equity: • $1M+ in potential equity • $400K in long-term gain If they sell without exchanging: ~$140,000–$160,000 lost to taxes If they exchange: • Keep the entire $400K • Reset depreciation • Trade into: - 2–3 newer properties - Sunbelt cash-flow assets - DST passive option - Inland Empire high-yield property In most scenarios, the exchange dramatically outperforms: • cash flow, • tax strategy, • long-term wealth building, • and risk profile. If this comparison makes the benefit obvious, you might be wondering:

Frequently Asked Questions About 1031 Exchanges

Q: How much time do I have to complete a 1031 exchange? A: You have 45 days from the sale of your property to identify potential replacement properties in writing, and 180 days total to close on the new property. These deadlines are strict, cannot be extended, and the clock starts the day escrow closes on your sale—not when you start looking. Q: Can I take out cash during a 1031 exchange without paying all the taxes? A: Yes. You can structure a partial exchange to take $50,000–$100,000 in cash while deferring taxes on the remainder, depending on your lender guidelines, equity position, and income profile. The cash you receive (called "boot") will be taxable, but you still defer taxes on the exchanged portion. Q: What happens if I can't find a suitable replacement property in time? A: If you can't identify a property within 45 days or close within 180 days, the exchange fails and you owe the full tax bill on your gains. This is why experienced investors line up potential replacement properties before listing their current property for sale, and build contingencies into their purchase contracts. Q: Can I exchange one property for multiple properties? A: Absolutely. Many LA investors use 1031 exchanges to diversify from one rent-controlled property into 2–3 properties in higher-performing markets, or into a Delaware Statutory Trust (DST) for completely passive ownership. You can identify up to three properties of any value, or more if they meet specific valuation rules. Q: Does California rent control (RSO/JCO) affect my 1031 exchange strategy? A: Yes, significantly. Properties under RSO or Just Cause Ordinance often have rents 40–70% below market with no realistic path to increase them. This makes them ideal candidates for exchanging into less-regulated markets with stronger cash flow, newer construction, and better long-term appreciation potential. Q: Do I lose my depreciation if I do a 1031 exchange? A: No—the opposite. Your depreciation carries forward, but you also get a new, higher basis for the replacement property, effectively resetting your depreciation clock. This is one of the most powerful benefits of a 1031 exchange, especially if you've exhausted most of your depreciation on the current property.

Why Working with a 1031 Exchange Specialist Matters

An experienced 1031 exchange advisor provides critical guidance throughout this process: ✓ Interpreting your Schedule E to reveal true property performance ✓ Calculating your actual return on investment ✓ Running comprehensive 1031 Exchange Analysis comparisons ✓ Identifying whether an exchange genuinely improves your financial position ✓ Preparing your property to maximize leverage in the sale ✓ Building time extensions into sale contracts ✓ Lining up replacement properties before listing ✓ Coordinating the entire professional ecosystem (CPAs, Qualified Intermediaries, attorneys) ✓ Helping you avoid six-figure mistakes Most tax professionals and real estate agents don't specialize in exchanges. Working with a dedicated 1031 specialist simplifies what can be an overwhelming decision and ensures every detail is handled correctly. The difference between a successful exchange and a costly mistake often comes down to having someone who understands both the LA market's unique challenges and the technical requirements of 1031 transactions.