Reinvesting the money does nothing for your taxes. This is the single most expensive misconception I encounter at the closing table, and it costs the sellers who hold it hundreds of thousands of dollars.
There is no rule in the tax code that says "if you buy another building, you don't owe tax." Plenty of sellers believe there is. They take the cash, buy a replacement property, and discover the following April that the IRS and the California Franchise Tax Board both want their share of the gain — in full, in the year of the sale.
What actually defers the tax is a specific, formal transaction called a 1031 exchange, and the difference between "I reinvested" and "I did a 1031" is the difference between owing nothing now and owing the entire bill now. Same cash. Same replacement building. Completely different tax outcome. The mechanism is what matters, not the reinvestment.
A sale is a taxable event the moment you receive the proceeds. The IRS calls this "constructive receipt" — the instant the money hits your account or your right to direct it, the gain is recognized and the tax is owed. What you do with the money afterward is irrelevant to that recognition.
Buy a yacht, buy a treasury bond, buy another twelve-unit in Van Nuys — the tax treatment is identical in all three cases. The proceeds touched your hands, so the gain is realized. The reinvestment is a separate transaction the tax code does not care about.
This is the trap: the act that triggers the tax is taking the money, and a casual reinvestment requires you to take the money first. That is the exact thing a 1031 exchange is engineered to prevent.
A 1031 exchange defers the capital gains tax — and the depreciation recapture, which for long-held LA buildings is often the larger number — by routing the entire transaction so you never take constructive receipt of the proceeds. The mechanics are rigid, and rigidity is the point. Miss one element and the deferral collapses into a fully taxable sale.
A qualified intermediary, an independent third party, must be engaged before the relinquished building closes. The intermediary holds the sale proceeds. You never touch them. If the money flows to you first, the exchange is dead before it starts — there is no fixing it after the fact.
Then the clock runs. You have 45 calendar days from closing to identify your replacement property in writing, and 180 days to close on it. Both deadlines are continuous and unforgiving. The 45-day identification deadline is where most failed exchanges fail, almost always because the seller treated 45 days as the time to start searching rather than the time to confirm a decision already made.
Sellers assume a 1031 is all-or-nothing. It is not. You can defer some of the gain and pay tax on the rest, and the part you pay tax on is called "boot."
Boot is any value you walk away with that didn't roll into the replacement property. Two kinds catch sellers off guard. Cash boot is proceeds you keep instead of reinvesting — pull $300,000 off the table to pay down a personal debt, and that $300,000 is taxable now even if the rest of the exchange is flawless. Mortgage boot is subtler: if your old building carried a $2 million loan and you replace it with a building carrying only a $1.4 million loan, that $600,000 reduction in debt is treated as taxable value received, because you were relieved of a liability.
To defer the full gain, you generally have to trade up — equal or greater value, equal or greater debt, all proceeds reinvested. Take any of it out, in cash or in reduced debt, and that slice gets taxed. And here is the part that stings: boot is taxed against your depreciation recapture first, at the higher recapture rate, before it ever touches the lower capital-gains rate. The cash you kept is the most expensive cash in the deal.
The misconception often comes from a real rule that applies to a different asset. When you sell your primary residence, Section 121 lets a single owner exclude up to $250,000 of gain, and a married couple up to $500,000, with no requirement to reinvest a dime. You can take the cash and spend it.
That exclusion is for the house you live in. It does not apply to an apartment building you rent to tenants — an investment property has no such free exclusion, and no amount of reinvestment substitutes for one. Sellers who once sold a home tax-free assume the same logic carries over to their fourplex. It does not. Two different statutes, two different worlds.
California follows the federal 1031 rules. A properly structured exchange defers your California tax alongside the federal tax, which matters in a state where capital gains are taxed as ordinary income at rates reaching 13.3% — among the highest in the country. A blown exchange isn't just a federal problem; it detonates the state bill too.
California adds one wrinkle. If you exchange a California building for one out of state, the state requires an annual filing (Form 3840) to track the deferred gain, and it intends to "claw back" its share when you eventually sell that out-of-state replacement in a taxable transaction. The deferral travels with you. So does California's claim on it. If you're weighing whether to exchange out of California entirely, the claw-back is part of that math.
Decide whether you want a 1031 before you list, not after the offer comes in. The single most common way I watch sellers lose the deferral is sequencing: they accept an offer, close, take the check, and then call their CPA to ask how to avoid the tax. By then the answer is that they can't. The structure has to exist before the money moves.
If a 1031 is on the table, engage the qualified intermediary early, line up replacement candidates before closing, and have a fallback — a Delaware Statutory Trust identification will close an exchange that would otherwise collapse when your primary replacement falls through. And before any of this, get the real tax number from your accountant. The gain you'll owe on is driven heavily by depreciation recapture, which most sellers underestimate badly. The decision to exchange should be made against the true bill, not a guess.
Reinvesting your money is what you do with the proceeds. A 1031 exchange is how you sell in the first place. Sellers who confuse the two believe they're protected right up until the tax bill arrives, and by then the only thing left to decide is how to pay it. The cash is the same either way. The structure is everything.
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Michael Sterman is Senior Managing Director Investments at Marcus & Millichap, specializing in Los Angeles multifamily transactions.
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