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.
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:
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.
Here are some of the more specific provisions in California.
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.
The state is one of the few in the country that requires mandatory tax withholding at the time of sale, even for 1031 exchanges.
This withholding requirement is essentially a way for California to collect tax if the exchange fails or if boot is received.
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.
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.
Given the unique requirements California imposes, it’s critical for investors to understand the nuances and plan with all the needed information.
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/