The like-kind exchange is mostly a federal transaction, but some states have unique rules that investors must keep in mind to avoid issues and maintain tax-deferred status. For those exchanging in California, Form 3840 comes to mind. This document serves a crucial purpose in reporting capital gains, and filing it out accurately helps you maintain compliance with state-level rules and avoid costly penalties.
Below, Realized 1031 shares insights into the purpose of Form 3840 in California 1031 exchanges, providing guidance if you’re moving out of state after an exchange.
A 1031 exchange allows you to defer capital gains taxes under a framework set by the IRS. As you reinvest proceeds from a relinquished property to acquire a new one, there is no gain or loss recognized, resulting in the tax deferral benefits.
Of course, the tax deferral only applies at the federal level. States have their own rules regarding state-level capital gains taxes. California accepts the tax-deferral benefits of the exchange, but the state government is vigilant about tracking deferred gains when a California property is exchanged for another asset outside the state. More specifically, California wants to ensure that it can collect its share of taxes if and when the gain is eventually recognized. This is called the clawback provision, and a few other states also have this rule.
Also called the California Like-Kind Exchange document, Form 3840 is the state-specific tax reporting form used to disclose information about 1031 Exchanges involving California property. It helps the California Franchise Tax Board (FTB) monitor deferred capital gains tied to property that may no longer be within the state’s taxing jurisdiction.
The main purpose of Form 3840 is to notify California of a deferred gain resulting from a 1031 exchange. The form also serves as the official proof that preserves the state’s right to clawback the future realized taxable gain. Without this reporting mechanism, the state may lose visibility in taxable gains, which leads to a loss of income from taxes involving these major real estate transactions.
Generally, you are required to fill out and submit Form 3840 under these circumstances.
You are not required to file the form if the involved properties are located within California. If you fail to file the form when the exchange qualifies, then you may face penalties and additional scrutiny from the FTB.
You’ll need to supply the following information in the FTB form.
The information helps California keep a record of the transactions and assess the appropriate tax once a taxable event occurs.
If you fail to file Form 3480, you may encounter problems in the future. First, FTB sends a Notice of Proposed Assessment, which adjusts the income for the California-sourced deferred gain. The FTB will also charge penalties for noncompliance and interest on unpaid state taxes. Due to the failure, you may also face increased scrutiny from FTB for future California property exchanges.
In some cases, the FTB may assume that the deferred gains were recognized earlier than they actually were. This may also result in unexpected tax assessments.
Given the future consequences of Form 3840, investors must consider these documents as part of their long-term tax strategy. Accurate reporting ensures proper documentation of deferred gains and streamlines future exchanges. Plus, filing the form helps maintain accurate cost basis calculations. The overall benefit is fewer bureaucratic burdens, the avoidance of surprise penalties, and smoother estate planning. Investors who plan to continue exchanging properties or eventually pass assets to heirs benefit from clean, well-documented exchange histories.
Form 3840 is a critical piece of the document that allows California, particularly the FTB, to track 1031 exchanges and deferred capital gains tied to in-state real estate. Even when replacement properties are located beyond the state, Form 3840 ensures that California can clawback the deferred taxes. For investors, filing this form is crucial to maintain compliance, avoid penalties, and preserve tax-deferral benefits.
Sources:
https://www.ftb.ca.gov/forms/2024/2024-3840-instructions.html
https://calawyers.org/real-property-law/what-is-a-1031-exchange/
https://www.ftb.ca.gov/file/personal/reporting-like-kind-exchanges.html