Tax Law ✦ Real Estate Tax Strategy
California Real Estate Has Its Own Tax Code. Plan for It.
1031 exchanges with California’s claw-back, Proposition 19 and the end of the old parent-child exclusion, cost segregation under California’s non-conforming depreciation rules, the 13.3 percent state rate on gains, nonresident withholding, and the basis step-up that community property doubles. North Star Law Firm plans real estate transactions for owners, investors, and families with both tax codes in view. Attorney-CPA. Flat fees. Statewide.
The Short Answer
The federal strategies work in California. The state adds a layer to each one.
A Section 1031 exchange defers gain federally and in California, but California requires you to report the deferred gain every year on Form 3840 if the replacement property is outside the state, and taxes it when that property is finally sold. Depreciation and cost segregation accelerate deductions federally, but California does not allow bonus depreciation and caps the Section 179 deduction at $25,000, so the state benefit is smaller and the records have to be kept two ways. Proposition 19 ended most parent-to-child property tax exclusions in 2021, so a house passed to children is usually reassessed unless it becomes their principal residence. And California taxes capital gains as ordinary income at rates up to 13.3 percent, with no preferential rate, which makes the timing and structure of a sale worth more here than almost anywhere.
- Section 1031 exchanges, reverse and improvement exchanges, and California Form 3840 reporting
- Cost segregation, depreciation planning, and the federal-California depreciation split
- Proposition 19: parent-child and grandparent-grandchild transfers, base-year value transfers for owners 55 and older
- Sale timing, installment sales, and the interaction with the 3.8% net investment income tax
- Nonresident and out-of-state owners: 3⅓% withholding (Form 593), sourcing, and residency
- Basis step-up at death, community property planning, and holding property in a living trust
The Rules
Where federal and California real estate tax rules diverge
Most owners plan from the federal rules and get surprised by the state ones. These are the differences that come up most.
| Issue | Federal | California |
|---|---|---|
| Capital gains rate | 0%, 15%, or 20%, plus 3.8% NIIT | Ordinary income rates up to 13.3%; no preferential rate |
| 1031 exchange | Gain deferred (I.R.C. § 1031) | Deferred, but annual Form 3840 reporting for out-of-state replacement property and tax on the deferred gain when it is sold (R&TC § 18032) |
| Bonus depreciation | Available on qualifying property | Not allowed; California uses its own depreciation schedules |
| Section 179 | Federal limit in the millions | Capped at $25,000 |
| Primary residence exclusion | $250,000 / $500,000 (§ 121) | Conforms |
| Property tax on inheritance | No federal property tax | Prop. 19: parent-child exclusion only for a principal residence the child occupies, limited to assessed value plus $1 million |
| Withholding on sale | FIRPTA for foreign sellers | 3⅓% of the sale price (or elective gain-based amount) withheld from most sellers who are not California residents or who fail an exemption, Form 593 |
| Basis at death | Step-up to fair market value (§ 1014); both halves of community property | Conforms, including the community property double step-up |
How does a 1031 exchange work, and where do California owners go wrong?
You sell investment or business property, a qualified intermediary holds the proceeds, you identify replacement property within 45 days and close within 180 days, and the gain is deferred into the new property’s basis. The rules are unforgiving: touch the proceeds and the exchange fails; miss the identification deadline by a day and it fails; buy down in value or debt and the difference is taxed. California owners have two extra traps. If the replacement property is outside California, the deferred California gain follows you: Form 3840 must be filed every year, and California taxes the deferred gain when the out-of-state property is sold, even if you have long since left the state. And an exchange into property held in a different entity than the one that sold can fail the same-taxpayer requirement, which is where planning before escrow opens matters most.
What did Proposition 19 change, and what can still be done?
Before February 16, 2021, a parent could transfer a home and up to $1 million of assessed value in other property to a child without reassessment. Proposition 19 limited the exclusion to a family home or farm that the child makes a principal residence within one year, and capped the excluded value at the assessed value plus $1 million; everything else is reassessed to market value on transfer, including at death. For a rental property held since 1990 that is a property tax increase of thousands of dollars a year, forever. Planning options exist, including certain LLC and trust structures that avoid a change in ownership, and the base-year transfer that lets owners 55 and older take their assessed value to a new home anywhere in the state up to three times. Each has strict requirements, and the county assessor audits them.
When does an out-of-state or nonresident owner owe California tax?
Always, on California real estate. Rent and gain from California property are California-source income regardless of where the owner lives (R&TC § 17951), a nonresident owner files a Form 540NR, and the buyer’s escrow withholds 3⅓ percent of the price unless the seller qualifies for an exemption or elects the alternative gain-based withholding on Form 593. Owners who left California and still hold property here, or who sold on an installment note before leaving, have a continuing California filing obligation, and the FTB’s residency audits reach exactly that population. We handle the sourcing analysis, the withholding elections, and the residency documentation.
The Attorney-CPA Difference
Two tax codes, one property. We plan for both.
- Exchanges structured before escrow opens, with the same-taxpayer and identification rules checked
- Depreciation and cost segregation modeled with the federal and California difference tracked
- Proposition 19 planning for family transfers, with the assessor’s requirements in view
- Nonresident withholding and sourcing handled at closing, not at audit
- Trust, entity, and basis planning coordinated with the estate plan
Questions & Answers
Real estate tax questions California owners ask
Can I do a 1031 exchange into property in another state?
Yes. The federal deferral works, and California allows it, but California will require annual Form 3840 reporting and will tax the deferred California gain when the out-of-state property is sold. It is still often worth doing; it just is not a way to leave the California gain behind.
Should I put my rental in an LLC?
For liability, usually yes. For tax, the LLC is disregarded or taxed as a partnership, so nothing changes federally, but California charges the $800 annual tax and the gross-receipts fee on the LLC. The transfer into the LLC must also be handled so it does not trigger a property tax reassessment.
Will my children be reassessed when they inherit the house?
Under Proposition 19, yes, unless the child moves in and makes it a principal residence within a year, and even then only the assessed value plus $1 million is protected. Rental and vacation properties are reassessed at market value. There are structures that can help if planned in advance.
Does California honor the $500,000 home sale exclusion?
Yes. California conforms to § 121, so a married couple excludes up to $500,000 of gain on a principal residence they owned and lived in for two of the last five years, and gain above that is taxed at ordinary California rates.
Plan the transaction before escrow opens. After is too late.
A free transaction review with an attorney-CPA, and a flat fee in writing before you commit.