State Guides
California Will Follow Your Gain Out of State
You can exchange a California property for one in Texas. California still expects to be paid when you eventually cash out, and it files a form to remember.
Illustration generated for this article by 1031 Exchange News Today.
California allows 1031 exchanges and conforms to the federal deferral. What it does not do is forget. Exchange a California property for one in Nevada and California still considers the gain accrued within its borders to be its own, payable whenever you eventually sell for cash.
How the clawback works
The rule, in place since 2014, applies to any taxpayer who exchanges California real property for real property outside the state and defers gain. California tracks that deferred California-source gain indefinitely, and taxes it when the replacement property is eventually disposed of in a taxable transaction.
The gain does not become Nevada's or Texas's simply because the property is now there. The portion attributable to the original California property remains California-source.
What happens if you stop filing
The Franchise Tax Board may estimate and assess the deferred gain, and it has been willing to do so. Because the filing requirement is annual and easy to overlook once you have moved out of state, this catches people years later, with interest attached.
A worked example
An investor sells a Los Angeles rental with a $700,000 gain and exchanges into an Austin property. No California tax is due at the time. Six years later the Austin property is sold outright for a $1,000,000 total gain.
| Component | Amount | Taxed by |
|---|---|---|
| Original deferred California gain | $700,000 | California |
| Additional gain accrued in Texas | $300,000 | Federal only; Texas has no income tax |
| Total federal gain | $1,000,000 | Federal |
The investor pays California tax on $700,000 despite not having owned California property for six years, and despite living elsewhere.
Keeping the deferral alive
The clawback only bites on a taxable disposition. Keep exchanging and the California gain keeps deferring, alongside the federal gain. Each subsequent exchange requires another Form 3840.
Under current law, property held until death receives a stepped-up basis, which can eliminate the deferred California gain as well as the federal one.
Other states doing the same thing
California is the most aggressive but not alone. Montana, Oregon and Massachusetts have their own tracking mechanisms, and several states impose withholding on sales by non-residents that has to be addressed at closing even when an exchange is planned.
Disclosure
This article is published by Easy1031, a qualified intermediary with a commercial interest in readers starting an exchange. The rules and mechanics described here are the same whichever intermediary you use. Nothing here is tax or legal advice.
