It may seem that only federal tax laws apply to 1031 exchanges, but you have to remember that states also impose capital gains taxes. California, one of the most prolific states for real estate investing, follows federal rules regarding like-kind exchanges, but there are also state-specific rules that bodies like the Franchise Tax Board (FTB) implement.
Below, Realized 1031 shares these state-level provisions for transactions in California so you can be better prepared.
1031 Exchange California Requirements vs. Federal Laws
California follows the framework set by Section 1031 of the Revenue Code for like-kind exchanges. This means that transactions must follow rules like the following to remain eligible for the tax-deferred status:
- 45-day identification period and 180-day timeline
- Like-kind properties only (both real assets must have been held for investment or business use)
- Use of a qualified intermediary to facilitate handling of funds and avoid the creation of a constructive receipt.
Beyond these, the state layers in a few rules to ensure that it doesn’t miss out on the deferred capital gains taxes if an exchange happens outside of the state.
Specific California 1031 Exchange Rules
Here are some of the more specific provisions in California.
1. California 1031 Clawback Tax Rule
The state requires investors who are acquiring replacement properties from out of state to file Form 3840 every year the replacement property is held. This documentation allows the FTB to keep track of deferred gains so that when a taxable event ultimately occurs, the state can “claw back” the deferred taxes from the initial property sale.
Failing to file this form can lead to penalties and interest for the unpaid taxes. California isn’t the only state that imposes the clawback provision, as these rules remain critical for ensuring that states don’t lose out on income from taxes.
2. Mandatory Real Estate Withholding Rules
The state is one of the few in the country that requires mandatory tax withholding at the time of sale, even for 1031 exchanges.
- The Rule: By default, California requires a withholding of 3.33% of the total sales price.
- For 1031 Exchanges: Investors may claim an exception by filing Form 593. However, this is only applicable if the exchange is for the full value of the property.
- Boot: If the investor receives any non-like-kind property during the exchange, like cash, then the qualified intermediary must withhold taxes on that amount if the boot exceeds $1,500.
This withholding requirement is essentially a way for California to collect tax if the exchange fails or if boot is received.
3. Requirements for Qualified Intermediaries
Compared to other states, California has stricter rules on who can work as a qualified intermediary. For starters, intermediaries must have a bond of at least $1 million or keep funds in a separate escrow account. They must also maintain an errors and omissions policy covering at least $250,000. Finally, the qualified intermediary must act as a fiduciary and follow the “prudent investor” standards when handling exchange proceeds.
On your end as an investor, you must engage with intermediaries (called an exchange facilitator in California) that satisfy these requirements. Otherwise, the validity of the exchange in California may be compromised.
4. Non-conformity on Personal Property
The IRS limits 1031 exchanges to only real property based on the Tax Cuts and Jobs Act of 2017. However, the state’s tax code often takes a different stance on conformity. Pre-2018 assets follow different “like-kind” standards for personal property (like equipment or vehicles) that were once allowed federally but are now excluded.
Today, California follows a more granular approach to allocating value between real estate and personal property compared to federal law. In simple terms, California may require you to separately identify, value, and recognize gain on the personal property portion of a transaction. This may create state-level tax liability that doesn’t exist at the federal level.
Planning Around California Like-kind Exchange Regulations
Given the unique requirements California imposes, it’s critical for investors to understand the nuances and plan with all the needed information.
- Before executing an exchange, make sure that the withholding tax is calculated, not just the federal implications.
- Fill out Form 3840 for out-of-state replacement properties or exchanges involving properties across multiple locations (including California).
- Engage with 1031 exchange experts who are well-versed in the state’s distinct laws.
Wrapping Up: California’s State-Specific 1031 Exchange Rules
California has distinct rules for 1031 exchanges, which ensure the validity of an exchange, track the transactions, and make sure that the state doesn’t lose out on income from capital gains. For investors, understanding these state rules before beginning an exchange helps ensure a streamlined process, avoid unexpected penalties, and increase the chances of a successful exchange.
Sources:
https://www.irs.gov/pub/irs-news/fs-08-18.pdf
https://calawyers.org/real-property-law/what-is-a-1031-exchange/
https://www.ftb.ca.gov/forms/2025/2025-593-instructions.html
https://law.justia.com/codes/california/code-fin/division-20-5/section-51000/
