The Rules for a California Like-Kind Exchange

A like-kind exchange, also known as a 1031 exchange, allows investors to defer capital gains taxes on the sale of a business or investment property by reinvesting the proceeds into a new, similar property. While the foundational rules for these exchanges are set at the federal level, California applies these principles with its own distinct requirements.

The process is available for property held for productive use in a trade or business or for investment. An investor can defer state income taxes on a property’s gain, provided the proceeds are used to acquire a similar type of asset. Investors considering a property exchange involving California real estate must navigate these specific state-level regulations to ensure compliance and properly manage their tax obligations.

Core Principles of California Like-Kind Exchanges

For an exchange to be valid in California, it must first meet all federal criteria. At the federal level, tax deferral is limited to exchanges of real property. The concept of “like-kind” real estate is interpreted broadly, meaning an investor can exchange one type of investment real estate, such as an apartment building, for another, like raw land or a commercial office building.

California has unique rules regarding personal property. While federal law no longer permits like-kind exchanges for personal property, California continues to allow them for individual taxpayers with an adjusted gross income (AGI) below certain thresholds. For married couples filing jointly, heads of household, and surviving spouses, the AGI limit is $500,000, and for all other individual filers, the limit is $250,000.

For any qualifying exchange, the properties involved must be held for investment or for productive use in a trade or business. This excludes personal residences, second homes not used for rental purposes, and property held primarily for resale, known as “flips.” The transaction must be structured as an exchange rather than a sale and subsequent purchase.

Two timelines govern a deferred exchange. From the date the initial “relinquished property” is sold, the investor has 45 days to formally identify potential “replacement properties” in writing. Following the sale, the investor has a total of 180 days to complete the acquisition of the identified replacement property, and these deadlines are strict.

To prevent the investor from having actual or constructive receipt of the sale proceeds, the use of a Qualified Intermediary (QI) is required. The QI is an independent entity that holds the funds from the sale of the relinquished property and uses them to acquire the replacement property on behalf of the investor. This arm’s-length handling of funds is a requirement to ensure the transaction is treated as an exchange and not a taxable sale.

California’s Unique Reporting and Clawback Rules

California implements a “clawback” provision when an investor exchanges a California property for one located outside the state. This system is designed to ensure that capital gains originating from California real estate are eventually taxed by the state. While the gain is deferred at the time of the exchange, California establishes a mechanism to track it and collect taxes when a future taxable event occurs.

The core of this system is the requirement to file an annual information return, Form FTB 3840, California Like-Kind Exchanges. This form must be filed for the year of the exchange and every subsequent year until the replacement property is sold in a taxable transaction. This annual filing allows the California Franchise Tax Board (FTB) to maintain a record of the deferred tax liability, even if the taxpayer is no longer a California resident.

When an investor who exchanged a California property for an out-of-state property eventually sells that replacement property, the original deferred gain is “clawed back” and becomes taxable by California. The gain is reported on the taxpayer’s California income tax return for the year of the sale. This means that even if the investor has moved out of California, they are still obligated to file a California tax return to report the gain.

Conversely, if an investor exchanges an out-of-state property for a replacement property located within California, the transaction has different implications. The deferred gain from the out-of-state property is not subject to California’s clawback provision because the gain did not originate from a California source. The new California property will have a tax basis that reflects the deferred gain for future calculations.

Information and Documentation for a California Exchange

Properly executing a like-kind exchange in California requires record-keeping and the assembly of specific documents. A taxpayer must first gather all relevant financial details concerning the relinquished property to calculate the adjusted cost basis and final gain. This includes:

• The original purchase price
• A complete record of all capital improvements
• Records of all depreciation taken during the ownership period
• Closing statements showing the final sales price and related costs

For the replacement property, the necessary information includes the final purchase price, closing statements, and the date of acquisition. These details are necessary to demonstrate that the value of the new property is equal to or greater than the value of the relinquished property, a condition for full tax deferral. The closing statements for both properties provide a clear financial summary of each transaction.

The Qualified Intermediary will require its own set of information to facilitate the exchange, including the taxpayer’s personal information, details of both properties, and signed exchange agreements. The QI will also need the formal, written identification of potential replacement properties. When preparing California Form FTB 3840, you will need the addresses and assessor’s parcel numbers for both properties, the dates of acquisition and transfer, and the detailed gain calculation.

The California Filing Process

After gathering all necessary information, the taxpayer must follow a specific procedure to report the exchange to California. The primary action is to attach the completed Form FTB 3840 to the taxpayer’s annual California income tax return, such as Form 540 for residents or Form 540NR for nonresidents. The filing of Form FTB 3840 initiates a tracking process by the Franchise Tax Board, which records the deferred gain.

A defining feature of California’s rules is the ongoing annual filing requirement for taxpayers who exchanged California property for property outside the state. This obligation persists regardless of the taxpayer’s residency status and continues until the replacement property is sold or otherwise disposed of in a taxable event.

When the taxpayer eventually sells the out-of-state property, they must file a final Form FTB 3840, indicating that the property has been disposed of. This final filing is accompanied by the reporting of the original deferred gain on the taxpayer’s California tax return for that year, at which point the state assesses the applicable tax.

Should a taxpayer fail to meet this annual filing obligation, the FTB is authorized to take action. The agency can estimate the deferred gain based on available information and issue a notice of proposed assessment for the tax, along with interest and penalties.