California 1031 Exchange and Form 3840 Clawback

Listen to this analysis: North Star Tax and Legal Briefing (4 min 27 sec)

Episode transcript

A landlord in Riverside sells a fourplex for two point four million dollars, rolls the money into an apartment building in Fort Worth, and moves to Texas a few years later. No state income tax, California in the rearview mirror. Then the Franchise Tax Board sends a notice proposing tax on one point eight million dollars of gain, plus penalties and interest. Not because the exchange failed. Because the owner stopped filing one information form. California has a long memory, and when you swap California property for out of state property, the deferred gain stays tethered to Sacramento until the day it is finally taxed.

Start with the federal side. A like kind exchange lets you sell investment real estate and buy replacement real estate without paying tax on the gain right away. The key word is defer. The old basis carries into the new property, so the tax bill is postponed, not erased. California mostly follows the federal rule, but the stakes are higher here, because California taxes capital gain as ordinary income, at rates up to twelve point three percent, plus another one percent on income over a million dollars. And California follows a sourcing principle: gain that built up on California real estate is California source income no matter where you live when you finally recognize it. That is the distinction to hold onto. Deferral is federal and state, but the state’s claim never moves.

The delayed exchange traces to a decision called the Starker case, where a court blessed selling first and buying later. Congress then wrote in the deadlines: identify your replacement property within forty five days of closing, and receive it within one hundred eighty days, with a qualified intermediary holding the money so you never touch it. California adds two layers. First, withholding. Escrow generally holds back three and a third percent of the sales price unless you certify the sale is part of an exchange: on a two point four million dollar sale, that is eighty thousand dollars. If the exchange fails, or you take out cash above fifteen hundred dollars, the intermediary has to withhold anyway. Second, the annual leash. Buy your replacement property outside California, and you must file Form 3840 with the state every single year until the deferred gain is recognized. Stop filing, and the Franchise Tax Board may estimate the gain from any available information and assess it the way it handles a nonfiler. To be fair, the rule cuts both ways: when you eventually sell, California taxes only the California source portion. Appreciation earned in Texas belongs to Texas.

Run the numbers on that Riverside fourplex. Adjusted basis, six hundred thousand dollars. Sale price, two point four million. That is a one point eight million dollar gain, a quarter million of it depreciation recapture. Sell outright, and the combined federal and California bill lands near six hundred sixty thousand dollars. Exchange properly, and that entire bill is deferred, maybe forever. Keep swapping until death, and the basis resets. With the federal estate exclusion at fifteen million dollars per person, a family can pass the whole portfolio with the deferred gain wiped out for income tax purposes. But the compounding risk runs the other way. Miss the annual filing, and the state can assess the full deferred gain early, with penalties and interest stacked on top.

Three things to do this week. If you have exchanged out of California in any year since twenty fourteen, pull your returns and confirm that Form 3840 went in every single year; catching up quietly beats a proposed assessment. If you are planning a sale, get the qualified intermediary and the withholding certification lined up before escrow opens, not after. And if this is your retirement exit, look at the whole board: the exchange, the nonresident return, and the estate plan all have to line up, because the step up at death is where deferral becomes forgiveness. That’s what we do at North Star Law Firm. The initial consultation is free, and the full written analysis with citations is at ca-legal.net.

Every fall Inland Empire landlords get the same call from a broker: the Riverside fourplex or the Fontana industrial building is worth more than ever, and a buyer is ready. The like-kind exchange under 26 U.S.C. § 1031 is the usual way to defer the tax. What owners rarely hear about is the California piece that follows them out of the state: sell here, buy in Texas, and the Franchise Tax Board expects a return from you every year until the deferred gain is finally taxed.

How does a § 1031 exchange work under federal law?

Under 26 U.S.C. § 1031(a)(1), no gain or loss is recognized when real property held for investment or business use is exchanged solely for real property of like kind. Since 2018 only real property qualifies, and any domestic real estate is like kind to any other.

The sell-first, buy-later exchange traces to the Ninth Circuit. In Starker v. United States, 602 F.2d 1341 (9th Cir. 1979), the court approved an exchange for a promise to deliver like-kind property later. Congress then wrote the limits into § 1031(a)(3): identify replacement property within 45 days after the sale and receive it within 180 days. Treas. Reg. § 1.1031(k)-1 adds the identification rules and the qualified intermediary safe harbor that keeps you out of constructive receipt of the proceeds. Full deferral requires trading equal or up and replacing any debt paid off; cash or debt relief you keep is boot, taxed under § 1031(b). The old basis carries into the new property, so the gain is deferred, not erased.

Does California follow the federal rules?

Mostly. Revenue and Taxation Code § 18031 adopts the federal gain-and-loss provisions, including § 1031, “except as otherwise provided,” and for taxable years beginning on or after January 1, 2025, California limits exchanges to real property just as federal law does. The stakes are higher here because California has no preferential capital gains rate: gain is ordinary income taxed at rates reaching 12.3 percent, plus the 1 percent mental health services tax above $1 million. Add the federal rates and a top-bracket landlord faces a combined bite near 37 percent.

What is the Form 3840 clawback when you exchange out of California?

Revenue and Taxation Code § 18032 applies to exchanges in taxable years beginning on or after January 1, 2014. When gain on property “in this state” is deferred under § 1031 and the property acquired “is located outside of this state,” the taxpayer must file an information return “for the taxable year of the exchange and for each subsequent taxable year in which the gain or loss from that exchange has not been recognized.” That return is FTB Form 3840.

The logic is sourcing. Gain built up on California real estate stays California-source income no matter where the owner lives when it is recognized. Section 18032(b) supplies the teeth: if the taxpayer files neither the information return nor a California return, the FTB “may make an estimate of the net income, from any available information, including the amount of gain” and propose tax, interest, and penalties as in a nonfiler case under § 19087.

What happens to the 3.33 percent withholding at closing?

Under Revenue and Taxation Code § 18662(e), the buyer of California real property must withhold 3 1/3 percent of the sales price from an individual or trust seller unless an exemption applies. On Form 593 the seller can certify under penalty of perjury that the transfer is part of a § 1031 exchange, which excuses withholding to the extent gain is not recognized. Two traps follow. Boot above $1,500 must be withheld on by the qualified intermediary. And if the exchange fails within the 180-day window, the intermediary must notify the FTB within 10 days and withhold 3 1/3 percent of the sales price from the funds it still holds. On a $2.4 million sale that is $80,000.

What does the Riverside fourplex example look like from sale to year six?

A Riverside landlord bought a fourplex near the University neighborhood in 2009 and sells it on October 15, 2026 for $2.4 million. Adjusted basis is $600,000, so the gain is $1.8 million, $250,000 of it unrecaptured § 1250 depreciation. An outright sale in the top brackets would cost roughly $62,500 of federal tax on the recapture, about $310,000 on the remaining $1.55 million, around $68,400 of net investment income tax, and California tax approaching $220,000, about $660,000 in all.

Instead the owner hires a qualified intermediary, signs the Form 593 certification so nothing is withheld, identifies a $3 million apartment building in Fort Worth by November 29, 2026 (day 45), and closes by April 13, 2027 (day 180) with $600,000 of new financing. The Texas building takes a basis of roughly $1.2 million, and the 2026 California return includes Form 3840, refiled each year through 2031.

In 2032 the owner, now living in Fort Worth, sells for $3.6 million. Federally the gain is roughly $2.5 million after five years of depreciation on the carried basis. California gets a final Form 3840 and a nonresident return reporting $1.8 million of California-source gain at 2032 rates; the Texas appreciation is not California income. Had the owner stopped filing in 2029, the FTB could have assessed the $1.8 million then, with penalties and interest.

Item	Outright sale (2026)	Exchange to Texas	Year-six sale (2032)
Sale price	$2,400,000	$2,400,000	$3,600,000
Gain recognized federally	$1,800,000	$0	About $2,500,000
Form 593 withholding	$80,000	$0 (exemption certified)	Not applicable
Form 3840 filed	No	Yes, 2026 return	Yes, final year
California-source gain taxed	$1,800,000	$0	$1,800,000
Texas income tax	None	None	None

Does an exchange avoid Prop 13 reassessment, and what about Prop 19?

No. Proposition 13, article XIII A of the California Constitution, reassesses property on a change in ownership, and an exchange is one on both ends. An Ontario warehouse bought as replacement property gets a new base-year value equal to its price. Proposition 19, codified at Revenue and Taxation Code § 69.6, lets homeowners 55 or older, severely disabled, or displaced by disaster carry their base-year value to a replacement primary residence anywhere in California. It is a residence tool only; § 1031 never applies to a personal residence, so a retiree selling a Temecula home and a Corona rental runs two separate playbooks.

Can a retiring landlord exchange into a Delaware statutory trust or a vacation rental?

In Rev. Rul. 2004-86, the IRS treated a beneficial interest in a Delaware statutory trust holding rental real estate as an undivided interest in the property itself, so it works as replacement property. The price is a passive trustee: no renegotiating loans, no new leases outside narrow exceptions, no reinvesting proceeds. An out-of-state DST still triggers Form 3840.

Is a Palm Springs house the family uses a few weeks a year held for investment? Rev. Proc. 2008-16 offers a safe harbor. The IRS will not challenge a dwelling’s investment character if, in each of the two 12-month periods before the exchange (or after it, for replacement property), the owner rents it at fair rental for at least 14 days and personal use stays within the greater of 14 days or 10 percent of rental days.

How does swap till you drop work with the 2026 estate exemption?

A landlord who exchanges repeatedly and never sells is playing for the step-up. At death, 26 U.S.C. § 1014 resets the basis of the last replacement property to fair market value, and the accumulated deferred gain, Form 3840 balance included, disappears for income tax purposes. For 2026, 26 U.S.C. § 2010(c)(3) as amended by the 2025 reconciliation act sets the federal exclusion at $15 million per person, indexed after 2026, and California has no estate tax, so a married couple with $20 million of exchanged real estate and a well-drafted trust can pass it estate-tax free with a fresh basis for the children.

Frequently Asked Questions

Do I have to file California Form 3840 if I moved to Texas after my exchange?

Yes. Revenue and Taxation Code § 18032 requires the return every year until the California-source deferred gain is recognized, regardless of where you live. Stop filing and the FTB may estimate the deferred gain and issue a Notice of Proposed Assessment with penalties and interest.

Does California tax the gain when I finally sell my out-of-state replacement property?

It taxes the California-source portion, meaning the gain deferred when you sold the California property, at the rates in effect in the year of recognition. Appreciation on the replacement property in another state is not California income for a nonresident.

How do I avoid the 3.33 percent withholding when I sell California property in a 1031 exchange?

Complete Form 593 and certify under penalty of perjury that the transfer is part of a § 1031 exchange, and escrow will not withhold on the exchanged amount. If you receive boot over $1,500 or the exchange fails, the qualified intermediary must withhold 3 1/3 percent, which you recover as a credit on your California return.

Can I use a 1031 exchange on my primary residence in California?

No. Section 1031 covers only property held for investment or used in a business. A residence has its own tools, the federal § 121 exclusion of up to $250,000 of gain ($500,000 for a married couple) and the Prop 19 base-year transfer for homeowners 55 and older.

Will a 1031 exchange keep my Prop 13 property tax base on the new California property?

No. The replacement property is reassessed to its purchase price on the change in ownership, and the assessed value of the property you gave up does not carry over.

Is a Delaware statutory trust a good replacement property for a California landlord who wants to retire?

It can be. Rev. Rul. 2004-86 treats a DST interest as an undivided interest in the underlying real estate, so it qualifies as replacement property. The trade-offs are frozen trustee powers, illiquidity, and sponsor fees.

How North Star Law Firm Can Help

North Star Law Firm advises Inland Empire and Sacramento-area property owners on real estate tax strategy for § 1031 exchanges, Form 3840 compliance after an exchange out of state, Form 593 withholding, and FTB audit and assessment defense when a deferred gain is challenged. Phillip Zagotti is a California attorney and a CPA, which matters here because the exchange, the nonresident return, and the estate plan all have to line up. The firm coordinates exchange planning with revocable living trust design, and owners weighing a move should read the firm’s post on FTB residency audits after moving to Texas or Nevada.

If you are planning a sale this year or are unsure whether your Form 3840 filings are current, contact North Star Law Firm or schedule a consultation.

Section 1031 Exchanges in California: The Form 3840 Clawback That Follows You Out of State