Many real estate investors assume that once they’ve 1031 exchanged out of California and purchased replacement property in another state, California is no longer part of the equation.
Not necessarily.
California has a unique reporting requirement that allows the state to continue tracking deferred gain from the sale of California real property long after the replacement property has crossed state lines. If you are not aware of these rules, you may be surprised to learn that California could still have an interest in your transaction years down the road.
The California “Clawback” Rule
Suppose an investor sells real property located in California and completes a valid Section 1031 exchange into replacement property located in another state.
For federal tax purposes, the gain is usually deferred.
However, California does not simply forget about the deferred gain. The state requires taxpayers to report the transaction on Form FTB 3840 and continue filing that form annually while the California-source gain remains deferred and unpaid.
The purpose is straightforward: California wants to preserve its ability to potentially tax gain that originated from California real estate if that gain is later recognized in a taxable transaction.
This ongoing reporting requirement is commonly referred to as California’s “clawback” rule.
What Is Form FTB 3840?
Form FTB 3840, California Like-Kind Exchanges, is used to track deferred gain from California property that has been exchanged into replacement property located outside the state.
In general, taxpayers who exchange California real estate for out-of-state replacement property must file the form in the year of the exchange and continue filing it annually until the deferred California gain is ultimately recognized or otherwise resolved.
The reporting obligation can continue for years, or even decades, after the original exchange.
Why Does California Require Ongoing Reporting?
California’s position is that the gain was generated while the property was located within California.
As a result, the state wants to maintain a record of that deferred gain, even if the replacement property is now located elsewhere.
The state’s interest follows the deferred California gain, not necessarily the physical property itself.
What Happens If the Replacement Property Is Sold?
If the out-of-state replacement property is eventually sold in a taxable transaction rather than exchanged again, California may seek to tax the portion of gain that originated from the original California property.
This is why ongoing reporting is important. California wants visibility into whether and when that deferred gain is ultimately recognized.
What If Another 1031 Exchange Occurs?
Many investors complete multiple 1031 exchanges over time.
In those situations, California generally continues tracking the deferred California-source gain through subsequent exchanges. The reporting requirement may continue even though the taxpayer may not have owned the original California relinquished property for several years.
What About Estate Planning?
A common question from the heirs of investors is whether California can collect tax on deferred gain if the investor dies before the gain is recognized.
The answer depends on several factors, including the taxpayer’s estate plan, ownership structure, and applicable federal and state tax rules. Because these situations can be highly fact-specific, investors should consult with their CPA, tax advisor, or estate planning attorney regarding their circumstances. Generally, heirs can get a “stepped-up” basis in property that they receive as an inheritance. Internal Revenue Code Section 1014 states that heirs receive property with a new basis that is set at the fair market value (FMV) as of the date of death of the decedent (https://www.law.cornell.edu/uscode/text/26/1014). This may deprive the State of California of its long-awaited recognition of gains.
Don’t Overlook the Filing Requirement
One of the biggest risks is simply forgetting that the reporting obligation exists.
Investors often focus on successfully completing the 1031 exchange and acquiring replacement property, only to overlook the annual reporting requirement that follows.
Failure to file Form FTB 3840 when required may result in California penalties, interest, or other compliance issues.
The Bottom Line
Completing a 1031 exchange out of California does not necessarily end California’s involvement.
If California real estate is exchanged for replacement property located outside the state, taxpayers may have an ongoing obligation to file Form FTB 3840 each year until the deferred California-source gain is ultimately recognized or otherwise resolved.
For investors with California property, understanding these rules is an important part of the long-term planning process.
As always, qualified intermediaries facilitate the exchange transaction itself. Tax reporting and compliance matters should be reviewed with a CPA or tax advisor to ensure all filing obligations are properly addressed.
This article is for educational purposes and should not be read as tax, legal, or accounting advice. Readers should consult their CPA, tax advisor, or legal counsel regarding their specific situation.
Jeff Peterson is a Minnesota attorney and former adjunct professor of tax law. He serves as President of Commercial Partners Exchange Company, LLC, where he facilitates forward, reverse, and build-to-suit 1031 exchanges nationwide. Jeff regularly collaborates with attorneys, accountants, and real estate professionals on exchange strategies. Reach him at 612-643-1031 or [email protected] or on the web at www.cpec1031.com.
